Story by Hein & Associates
Is there even any good news associated with that statement? As you know, depressed commodity prices bring dramatically lower valuations as suppressed profitability reduces cash flow generation and well economics.
However, there still is some good news. Right now, wealth transfer should be considered. With pricing and values lower, it is a good time to transfer or gift if one believes prices will increase. The gift will be at lower values and therefore utilize a lower percentage of your gift exclusions or credits, and can get a higher percentage of the property out to donees/recipients/beneficiaries.
More and higher lifetime transfers can be made at lower costs. This provides a huge opportunity. Gifting is more attractive now than at any point in the past several years. Gifting can be made through outright gifts, sales to defective trusts, forming grantor retained annuity trusts, or even gifting of partnership interests.
An outright gift always assumes the asset will increase in value again. If the asset is owned individually, the gift can be done as a transfer via deed. If the property is owned in a Limited Liability Company (LLC) or a Limited Liability Partnership (LLP), the units can be transferred. Besides having a lower value for the assets held in the entity, there would also be greater discounts associated with marketability discounts and minority interest discounts on the partnership or member interests.
The use of Grantor Retained Annuity Trusts (GRATs) can create tremendous results. This is a trust into which the donor transfers assets in exchange for a fixed annuity. The transfer, which is the remainder interest, results in a taxable gift which is based on a computation of the fair market value of the property less the present value of the retained interest. There is a fixed rate used in applying the computations. You always want to use assets that are more likely to earn more than this fixed Section 7520 rate. Generally, with the low Section 7520 rates and the annuity term, the gift value could be fixed at zero or close to zero. At the end of the term of the trust, the assets pass to the beneficiaries designated in the GRAT. This is beneficial for those who do not want to give everything away or have used virtually all of their gift exemptions. If the assets do not appreciate, they are returned to the donor. If the assets do increase in value, you have had the ability to transfer them out at a substantially reduced cost.
The use of a defective trust also allows the future value of the oil and gas production to accumulate and grow in trust and not in the donor’s taxable estate. In essence, a defective trust freezes the value of assets for estate planning purposes. Property is transferred in the trust and the donor receives back the current value of the transferred property via payments on the note used to purchase the property. There are also other rules of thumb that should be followed. There should be some money of least 10% of the purchase price of the property in the defective trust. This helps establish the economic substance of the trust. But generally, it is the equivalent of selling the property to you. There are no income or capital gains taxes on the sale. Currently, interest rates on the note are at historic low rates. The trust is defective in that it has a clause in it that treats it as a grantor trust so that all income is taxed to the donor. The trust assets, however, are excluded from the donor’s estate upon death.
One additional item to mention is the use of limited partnerships. In essence, the benefits of these for oil and gas interests is the ability to leverage annual gift tax exclusion and life-time giving exclusions by applying the lack of control and lack of marketability discounts while still retaining some control over the transferred properties or assets.
As always, estate planning for oil and gas interests require you to consider the valuation aspect. There are a number of types of mineral rights including fee interests, royalty interests, working interests, carried interests and production sharing contracts. Various valuation methods must be applied based on the type of interest. Often times, the market approach valuation can be done with working interests because there is substantial data to draw upon. Although, the same might not hold true for a royalty interest.
Through complex planning and design, consideration must be made to provide transfers through gifting type programs especially with the value of the property is at its lowest point in a number of years.
So after all of this, why pursue estate planning now? You can take advantage of the exemptions and credits, reduce the already reduced value through discounts, provide creditor protection, and leverage the use of the generation-skipping tax exemption. This provides greater savings for future generations. And as a final note, you potentially could avoid legislative changes by having the transaction be grandfathered under the old rules.
If we are going to have declining prices of oil and gas, let’s plan for the best way to help them become advantageous.
Hein & Associates provides comprehensive audit, tax and business advisory services. For more information about estate planning and the declining prices of oil and gas, contact Mira Finé, Tax Partner, mfine@heincpa.com or call 303-298-9600.
