Could someone please describe the tax benefits of forming a LLC for a natural gas rights owner. We are trying to plan for the balance of a lease signing bonus as well as future royalty payments. The property is located in PA but we live out of state.
Dont know about benefits... I do know that if you incorpoarte the LLC within the sate of PA the tax due to the state of PA on the royalty payments received by people residing outside the sate of PA MUST be deducted from their royalty disbursement and sent to the dept of revenue on a quaterly basis.
I know this because I am a member of an LLC that was formed within PA that has out of state members. Our LLC is a spinoff of a hunting club that is currently in two producing units.
It was quite the legal goings on to form the LLC quite a few people involved,lawyer advised us to get the lease owned by hunt club appraised by engineering firm that specilized in such appraisels to insure fair market value was obtained by the non profit so none of the non profits members could come back later and accuse LLC of ripping off the non profit..
Don't know your situation but things get complicated real quick...
How many members will your LLC consist of??
The benefits all depend how much property you have, the dollars involved and your ultimate goal (estate planning/gifting to future generations). An entity like a LLC gives you the ability to spread out the income to various members, some of which, may be at a lower tax bracket. You can also use the entity as a gifting vehicle by using your annual gifting amount to transfer LLC ownership interest to future generations (kids/grandkids). The issue you may have is what value do you place on the mineral rights? You can come up with some of the value based on the per acre lease bonus you'll receive. The hard part is what residual value do you place on the mineral rights for the future royalty income stream. You would need to figure out the total value, because this will be the initial contribution into the LLC when it is setup.
You also have to consider the additional cost of maintaining the LLC's books and records and filing an annual tax return. As Eric mentioned, there will be upfront costs (legal fees, valuation) associated with creating the LLC.
Instead of an LLC, you might be better off with a family limited partnership instead of an LLC for PA. Not only will the LLC's income be taxed, but LLC's are subject to PA's capital stock/franchise tax, but partnerships are not. This is a tax based on the entity's net equity. The tax is expected to be completely eliminated after 2014, but a lot can happen between now and then to prevent that from happening. You would still have the same costs setting up a partnership versus a LLC.
The income the LLC receives will pass through to the individual owners and the owners will report this income on their individual returns. As Eric mentioned, PA requires income tax withholdings for all members who live out of state. The out of state owners would need to file a PA tax return and report their share of the income and tax withheld on their behalf or the LLC could file what's called a composite return for all the nonresident PA members. This eliminates the need for the nonresident members to have to file a separate PA return.
These are just some general items to think about. I'm a CPA and head of our firm's oil & gas team. I'm working with clients on situations like yours. I'm also a landowner, so I'm not just doing planning for my clients, but also myself. If you would like to discuss your situation in detail and what may work best for you, please feel free to contact me.
Steven Kacerski, CPA
Steven, If you haven't leased yet, but have your LLC formed, how do you determine the value of the mineral rights in order to establish the initial contribution? We haven't had an offer yet and reside in Ohio. Thanks.
We had our lease/mineral rights appraised by an engineering firm before the LLC was formed and before the pooled units were formed but after the property was bound by the current lease. This worked out in our favor as the appraisal was lower because the gas under our property was considered a probable undeveloped non producing interest.
I would think you would be able to have the mineral rights appraised in the same manner even though you are not under a lease yet and hopefully it works to your benefit as well.
Thank you. We'll look into that option.
I agree with what Eric said in his reply. You would need to have a valuation done by an engineering/geology firm. For smaller acreage, you might be able to get away with having a CPA who specializes in valuations, but for larger acreage where there are more dollars at risk, it is worth spending the money upfront to have someone with an engineering/geology background do the valuation. Fees that I have heard could range from around $10k to $15k to get one done. If this is something you need to have done, I can provide you with the contact information of people who do this type of work. Please feel free to contact me
Our appraisel was done in March of 2011 for under $3000.
Our acreage is around 100 acres I would imagine the larger the parcel the higher the appraisal fee??
Steven, What is involved in having these appraisals done? Is it always necessary to do this in forming a LLC or a family partnership? Who can afford $10 to $15,000 when they are trying to PROTECT their interests for the family????? Is it cheaper to do this when the land is leased but not permitted or when the land is not leased yet?
As it was explained to us by our attorney the appraisel protects the members of the LLC from disgruntled parties claiming that the lease/mineral rights were bought for less than fair market value.
I do not think the cost for the appraisel should be affected by the land in question being or not being under lease.
The only benefit to having the appraisel done early in the game (before land is leased,pooled, drilled on and becomes a producing unit) is the appraisel will be lower and the purchase of the lease/mineral rights by the newly formed LLC will be more attainable for the members of the LLC
It all depends on the firm that does the appraisal and how much you want to spend. As I have told people at tax seminars I have done over the past year, there is no one size fits all tax solution for the oil & gas income. All of us own different amounts of land in different areas and we leased at different rates. I tell people this is why it is important to meet with their tax advisor to review their overall tax situation and estate plan. One of the reasons for forming a LLC or family partnership would be a gifting vehicle to transfer property from the older generation the younger generation. If this is the purpose for setting up the entity, you would need to come up with a value of the property so you know the total value of the LLC or partnership. This would be the starting point to determine how much ownership interest could be transferred to the next generation tax free. If the value of the property is not appraised and documented, the IRS could challenge it and come up with their own value.
As far as what is typically done, the geologists and engineers would come in and look at your property to determine what a person has below the surface. There would probably be some sort of seismic testing done to determine the rock formations on the property in order to determine the potential future royalty income stream from the property. What they would do is very similar to what the oil & gas companies would do. The people I have talked to and worked with have specific oil & gas background and experience which is important if you want the valuation to withstand any court challenges or IRS scrutiny. I know $10K-$15K sounds like a lot of money to pay a firm who specializes in this area. You are doing this to protect the interests of all members of the family involved. Just because everyone agrees and is happy with a decision today, doesn't mean they'll have that same feeling 5 to 10 years from now. I've seen too many times where people did not do the proper planning initially However, the issues one could have by not documenting the value of the property correctly could end up costing them more than that. In addition to Eric's reply about disgruntled parties, you could have issues with the IRS if the value is not documented and a proper appraisal was done for the property.
Hope this helps.
Eric and Stephen, Thank you for your answers. We are pretty overwhelmed with the procedure and the cost involved in this. Our acres have Marcellus Shale gas but how good it is and how important it will be in the future is still unsure. In other words, people are knocking on the door every so often but they are not camping out here. I would hate to spend this time and money and not get much out of it in the end. It seems to me that the majority of land owners might be like us and have no idea what to do concerning these estate questions.
Do we avoid this problem if we transfer portions of the land/ mineral rights now or in the near future?
If you're transferring property and not selling it, you would still need to determine the value of that property for gifting purposes. There could be gift tax consequences depending on the value of the property transfers. You may also need to file a gift tax return depending on the value of the property transferred to each person.
Another thing to think when gifting property, is the look back period for Medicaid. People will use gifts as a way to pass on some of their assets tax free to younger generations. This lowers the person's estate value and helps save on potential estate taxes. Where people need to be careful or at least consider, is that for medicaid purposes, medicaid can look back 5 years when they review whether a person has the assets to pay for care before medicaid would kick in. If a person were to gift property of $100,000 in 2012 and three years from now would need to go into a nursing home, they would count the $100,000 as your asset even though you no longer have the money. The reason for this is they don't won't people giving all their money away in order to get on government assistance. They want you to burn through all of your assets first. I know this is a little off topic, but it is something people need to consider when they start thinking about gifting/transferring property.