In the wake of the “Fiscal Cliff” deal in early January, I’ve received numerous calls from owners of mineral rights asking how the new law will affect them.  I’ve put together the following summary to help mineral rights owners understand the recent legislation, known as the “American Taxpayer Relief Act of 2012.”

3.8% Medicare Surtax for Taxpayers with Income over $200,000 or $250,000.  The new 3.8% surtax will affect single taxpayers with income over $200,000 and married couples with income over $250,000.  The tax will be levied on investment income to the extent it results in a taxpayer’s total income exceeding the $200,000 or $250,000 income threshold.  Because gas royalties are considered investment income, they will be subject to the 3.8% surtax, as will capital gain on the sale of land or mineral rights.

To illustrate how the surtax works, suppose Mike Smith, an unmarried individual, earns $100,000 in salary from his job at Proctor & Gamble in 2012.  In addition, he receives $200,000 in royalty payments from a gas lease.  His total taxable income would be $300,000.  Bob’s income would be subject to a top marginal rate of 33%, and the royalty payments would be subject to an additional 3.8% surtax to the extent the payments result in his income exceeding $200,000.  Specifically, the first $100,000 of his royalty payments would not be subject to the surtax because, together with Bob’s salary, that amount falls below the $200,000 income threshold.  The 3.8 percent surtax would only apply to the remaining $100,000 – the amount that results in Bob’s total income exceeding $200,000.  The surtax would result in an additional $3,800 in taxes for Bob.

Increase in Ordinary Income Tax Rates for Taxpayers with Income over $400,000 or $450,000.  Single taxpayers with income over $400,000 and married couples with income over $450,000 will see their marginal income tax rate rise from 35% to 39.6%.  Because gas bonuses and royalty payments are taxed at an individual’s ordinary income tax rate, landowners receiving significant bonuses or royalty payments could be affected by this change.

Increase in Tax Rates on Capital Gain and Dividends for Taxpayers with Income over $400,000 or $450,000.  Those in the highest tax bracket will also see an increase in the taxes they pay on capital gains and dividends.  The rate on capital gains and dividends will increase from 15% to 20% for these taxpayers.  This change could affect landowners who sell substantial gas rights, which would be subject to capital gain.  This rate increase works similarly to the 3.8% surtax, with a higher income threshold.

Changes to the Estate Tax.  The gift and estate tax rate will increase from 35% to 40%.  The amount exempt from the tax will increase from $5.12 million to $5.25 million per person.  The annual exclusion will increase from $13,000 to $14,000.  The provision allowing portability of the marital deduction between spouses is made permanent.

What does all this mean for mineral rights owners trying to plan their estate and make other important financial decisions? 

First, income shifting will take on added importance as a result of taxes that kick in only on income that exceeds certain thresholds.  Shifting income to other family members through gifts of property rights can help your family avoid the income tax increase on the highest bracket, the 3.8% Medicare surtax, and the increased tax rates on capital gains and dividends.  For example, if you and your spouse earn $500,000 in gas royalty income, you will be hit with a the income tax increase on couples earning more than $450,000, the 3.8% Medicare surtax, and the 20% tax rate on capital gains and dividends.  However, giving 20% of your property to your daughter will result in a taxable income for you and your wife of $400,000, just below the $450,000 threshold for the increased rates on income, capital gains, and dividends.  Additionally, only $150,000 of your royalty income will be subject to the 3.8% Medicare surtax, instead of $250,000.

Second, an estate tax exemption of more than $5 million per person will relieve most landowners of any federal estate tax liability.  In the absence of potential estate tax liability, families should focus on income tax planning, both through income shifting and maximizing depletion deductions.  In the estate context, keeping property instead of giving it to your children can help reduce your children’s income taxes after your death through higher depletion deductions.  The benefit of retaining ownership of gas rights must be weighed against the benefits from income shifting, described above, and the potential Pennsylvania inheritance tax liability.  Certain strategies involving trusts can achieve a reduction in both your children’s future income tax liability and their inheritance tax liability.

IMPORTANT:  The information provided here does not constitute legal advice, and readers should not act upon the information contained herein without consulting with legal counsel. 

CIRCULAR 230 NOTICE: Any tax advice contained in this written or electronic communication is not intended or written to be used to avoid any penalty imposed by a taxing authority, nor may the recipient of this communication, or any other person or entity use this written tax advice for that purpose.