Use of Family Limited Partnerships in estate planning for Marcellus/Utica gas leases
By Raymond M. Roberts
A Family Limited Partnership can be provide significant tax savings
You’ve negotiated your lease and will be receiving a generous signing bonus and an 18% gross royalty. The landman was tough, but you ended up with a very good lease with favorable terms. In ninety days, you will be receiving a very hefty check and you are probably thinking about a nice vacation, a new car (or in the case of a farmer, a new tractor) or paying off the mortgage. You should also think about doing some estate and tax planning as well. Many landowners receive their bonus and are shocked at the amount. As much as it may be, once drilling commences, the monthly royalty payments will quickly surpass the bonus. A farmer with 200 or 300 acres of land under a producing lease can quickly become a millionaire several times over in very short order. With proper planning, and using a special type of entity called a Family Limited Partnership (FLP), you can achieve significant tax savings, with respect not only to federal and state estate and inheritance taxes, but also current income tax. By utilizing the Family Limited Partnership and gifting strategies during your lifetime, these taxes can be reduced significantly and in the case of the state inheritance tax, be eliminated altogether.
Currently, federal estate taxes are assessed at a rate of 40% on assets over $5,340,000. If we assume a value for the real estate comprising the farm (not including the gas lease) of $3,500 per acre, a 300 acre farm will be worth $1,050,000 for the land alone (factor in equipment and livestock and an oil and gas lease and that number will increase significantly). It is very possible that your estate may quickly exceed the federal threshold and will be subject to federal estate taxes. Regardless, if you are a Pennsylvania resident, every cent of your estate is subject to Pennsylvania Inheritance Tax. This tax is based on the level of relationship between the deceased and the heir. If it is the deceased’s child who inherits, then the estate is taxed at a rate of 4.5%. If it is a sibling, the rate increases to 12%. If the heir is a niece or nephew, a same-sex partner or any other unrelated person, the rate increases to 15% of the value inherited by that person. If the estate contains property with a producing gas lease worth $10,000,000 and everything is left to the children by will, there will be a state inheritance tax due of $450,000 and federal estate tax of $1,864,000. If, instead of passing these assets at death, you transfer them into an FLP and utilize lifetime gifting strategies to transfer all of the interests to your children during your lifetime, the federal estate tax could be reduced to just $744,000 and the Pennsylvania inheritance tax could be completely eliminated for a potential tax savings of $1,570,000.
In addition to estate tax savings, by spreading the ownership among you and your children, you can achieve current income tax savings as well. Assume annual royalty payments of $500,000 per year; if those royalties are all taxable to you alone, they will be subject to federal income tax at the maximum rate of 39.6%. If you have three children and you make lifetime gifts to each of them so that you each will have a 25% interest, instead of one person receiving $500,000 taxable at a rate of 39.6% (for a tax of $198,000), you will have four people receiving $125,000 taxable at a rate of 25% (for a tax of $125,000).
Family Limited Partnerships have been used for years as an estate planning tool, especially with respect to real estate. Family Limited Partnerships are effective because IRS rules allow for taking discounts on the value of limited partnership interests that are gifted during the lifetime or transferred at death. Under the IRS rules, the value of limited partnership interests can be discounted for lack of marketability and lack of control. By using gifting strategies and taking advantage of the discounts allowed under the IRS rules, you can transfer significant wealth from one generation to the next while achieving significant savings on federal and state death taxes as well as current income tax savings. Another advantage of the Family Limited Partnership structure is that you can retain a level of control over the assets (and cash generated by those assets) as the sole owner of the general partner of the Family Limited Partnership (we recommend an entity such as an LLC as opposed to an individual acting directly as the general partner), even after all of your limited partnership interests have been gifted to your children.
There are, however, some downsides with the use of the Family Limited Partnership structure.
- Transfers of real estate into an FLP will be subject to Pennsylvania Realty Transfer Tax (unless the property being conveyed is a working family farm and the FLP is organized as a family farm business, in which case the transfer is exempt from Realty Transfer Tax). This tax is generally 2% of the fair market value of the property (although in some municipalities, the rate is higher).
- In addition, if the owner of the property resides on the property, the property can be brought back into the estate for federal estate tax purposes. The way around this is to subdivide the property and carve out the residence and an acre of land around it that will remain in the name of the owner, while the balance is transferred to the FLP. The cost of a subdivision varies from county to county and could cost as much as $5,000.
- When gifting interests during the donor’s lifetime, a gift tax return must be filed and an appraisal of the FLP assets, including the oil and gas reserves under the property must be prepared. (This appraisal would be required whether the transfer was by lifetime gift or at death.) The appraisal must be prepared by a properly credentialed geologist and a certified valuation analyst (CVA). The cost of this appraisal could range from $7,500 to $12,000.
While these costs may seem high, the savings in federal and state estate and inheritance taxes make it well worth the expense. Obviously, timing of these activities is important; it is best to wait until a lease is signed and a bonus is to be paid that will provide sufficient funds to cover these costs.
The Family Limited Partnership is one of several tools that can be used in estate planning with respect to shale gas leases. It may not be the best option for your particular situation. Please contact us to learn more about Family Limited Partnerships and estate planning strategies, or to find out if an Family Limited Partnership is the right choice for you.