Articles

Federal Taxation Issues
Affecting the Oil & Gas Industry

The purpose of this paper is to bring to your attention recent legislative changes affecting the oil and gas industry as well as to inform or possibly remind you of benefits built into the Tax Code which you may have the opportunity to utilize. The organization of the paper will be as follows:

1. Taxpayer Relief Act of 1997,
2. Recent Arkansas Legislation,
3. Tax-Deferred Exchanges, and
4. Estate Planning Issues.

The coverage given to any one topic is meant to be an introduction and/or overview only and by no means presents in depth coverage of the matter.

FEDERAL TAXATION ISSUES AFFECTING THE OIL AND GAS INDUSTRY

I. Taxpayer Relief Act of 1997

1. Taxable Income Limit Temporarily Suspended
2. Electing Large Partnership with Oil and Gas Activities

II. Recent Arkansas Legislation

Registered Limited Liability Partnerships and Registered Limited Liability Limited
Partnerships

III. Tax Deferred Exchanges: §1031 Exchanges

IV. Estate Planning Issues

1. Taxpayer Relief Act of 1997
   1. Unified Credit
   2. Qualified Family Owned Business
      1. Ownership Requirement
      2. Valuation
      3. Qualifying Estates
      4. Participation Requirements
   3. Cost-of-living Adjustments for the Annual Exclusion
2. Estate Planning Basics
   Lifetime Transfers
   1. Basic Rule #1
   2. Basic Rule #2
      1. Outright Gift
      2. Gift to a Trust
         1. Revocable Trust
         2. Irrevocable Trust
      3. Charitable Gift
   3. Transfers at Death
      1. Testate versus Intestate
      2. Marital Deduction

V. Conclusion

I. Taxpayer Relief Act of 1997

On August 5, 1997, President Clinton signed the Taxpayer Relief Act of 1997 (hereinafter called "the Act") which resulted in numerous changes to the United States tax laws. Specifically addressed here are some tax law changes which directly impact those in the oil and gas industry.

A. Taxable Income Limit Temporarily Suspended:

The Internal Revenue Code (hereinafter referred to as "the Code") allows taxpayers to recover their investments in oil and gas wells through depletion deductions. This recovery of investment may be determined using the percentage depletion deduction as set forth in § 613. However, while the Code allows recovery of investments in oil and gas wells, it also places limitations on this recovery. One such limitation is set forth in § 613(a) which provides that the depletion allowance shall not exceed 50 percent (100 percent in the case of oil and gas properties) of the taxpayer's taxable income from the property (computed without allowance for depletion).

Effective January 1, 1975, Congress placed additional limitations on percentage depletion in the case of oil and gas wells by the enactment of § 613(A). Section 613A(c)(6) specifically deals with oil and natural gas produced from marginal properties. To Code § 613A(c)(6), the Taxpayer Relief Act of 1997 adds subsection (H) which provides:

"The second sentence of subsection (a) of section 613 shall not apply to so much of the allowance for depletion as is determined under subparagraph (A) for any taxable year beginning after December 31, 1997, and before January 1, 2000."

Therefore, the 100-percent taxable income limit on percentage depletion deductions for oil and gas properties has been temporarily suspended for marginal properties for the tax years beginning after December 31, 1997, and ending before January 1, 2000. Section 613A(c)(6)(H) applies to marginal production defined as crude oil or natural gas that is produced from a domestic stripper well or from domestic property, substantially all of the production of which is heavy oil. Stripper well property is property from which the average daily production is 15 barrel equivalents or less, determined by dividing the average daily production of domestic crude oil and domestic natural gas from producing wells on the property for the calendar year by the number of wells.

B. Electing Large Partnership with Oil and Gas Activities:

Another benefit from the Act is the possibility of simplified flow-through reporting requirements for certain partnerships. With the addition of §§ 771 - 777 to the Code, large partnerships with 100 or more members may be eligible to significantly reduce the number of items that must be separately reported to their numerous partners. This simplification should ease the reporting burden on those partners affected. There are, however, restrictions placed on which types of partnerships are eligible to make such an election. For example, service partnerships and commodity pool partnerships are not eligible for the election. In addition, once an election of large partnership status is made, it applies to the tax year in which the election is made as well as all subsequent tax years and is irrevocable without the consent of the Internal Revenue Service ("IRS"). Therefore, careful consideration should be given prior to electing large partnership reporting.

The following briefly points out some of the differences in reporting for the electing large partnership:

1. Section 772(a) enumerates which items must be separately accounted for in determining the taxable income of a partner. However, items which most partnerships must state separately, but that escape the separate reporting of an electing large partnership are: short-term capital gains and losses; gains from sales of § 1231 property used in a trade or business; charitable contributions; miscellaneous itemized nonbusiness deductions; and separately enumerated alternative minimum tax preference items.

2. All "general credits" are separately reported to the partners as a single item. A partner's distributive share of the amount referred to in paragraph (6) of subsection (a) [general credits] is taken into account as a current year general business credit. A "general credit" is defined as any credit other than the low-income housing credit, the rehabilitation credit, and the credit for producing fuel from a nonconventional source. These non-general credits are separately reported.

3. Charitable deductions are allowed at the partnership level in determining the partnership's taxable income, subject to the 10-percent-of-taxable-income limitation applicable to corporate donors.

4. Miscellaneous itemized deductions are not separately reported to the partners. Instead these items are totaled and the partnership is allowed a deduction for 30-percent of the total miscellaneous items. This amount is not subject to the two-percent floor at the partner level.

5. All interests in the partnership will be treated as held by disqualified organizations for purposes of the tax on partnerships holding residual interests in a real estate mortgage investment conduit (REMIC).

6. Code §§ 771-777 apply to partnership tax years beginning after December 31, 1997.

The simplified flow-through reporting requirements have specific rules for electing large partnerships engaged in oil and gas activities. Section 776 provides:

(a) COMPUTATION OF PERCENTAGE DEPLETION

-- In the case of an electing large partnership, except as provided in subsection (b) --

(1) the allowance for depletion under section 611 with respect to any partnership oil or gas property shall be computed at the partnership level without regard to any provision of section 613A requiring such allowance to be computed separately by each partner,

(2) such allowance shall be determined without regard to the provisions of section 613A(c) limiting the amount of production for which percentage depletion is allowable and without regard to paragraph (1) of section 613A(d), and

(3) paragraph (3) of section 705(a) shall not apply.

(b) TREATMENT OF CERTAIN PARTNERS.

(1) IN GENERAL. -- In the case of a disqualified person, the treatment under this chapter of such person's distributive share of any item of income, gain, loss, deduction, or credit attributable to any partnership oil or gas property shall be determined without regard to this part. Such person's distributive share of any such items shall be excluded for purposes of making determinations under sections 772 and 773.

(2) DISQUALIFIED PERSON. -- For purposes of paragraph (1), the term "disqualified person" means, with respect to any partnership taxable year.

(A) any person referred to in paragraph (2) and (4) of section 613A(d) for such person's taxable year in which such partnership taxable year ends, and

(B) any other person if such person's average daily production of domestic crude oil and natural gas for such person's taxable year in which such partnership taxable year ends exceeds 500 barrels.

(3) AVERAGE DAILY PRODUCTION. -- For purposes of paragraph (2), a person's average daily production of domestic crude oil and natural gas for any taxable year shall be computed as provided in section 613A(c)(2).

(A) by taking into account all production of domestic crude oil and natural gas (including such person's proportionate share of any production of a partnership),

(B) by treating 6,000 cubic feet of natural gas as a barrel of crude oil, and

(C) by treating as 1 person all persons treated as 1 taxpayer under section 613A(c)(8) or among whom allocations are required under such section.

Therefore, electing large partnerships with oil and gas activities will generally follow the same simplified reporting requirements as other electing large partnerships. However, since depletion is generally computed at the partnership level, certain partners are treated as "disqualified persons," and fall under special reporting rules to prevent the extension of percentage depletion deductions to those persons who would otherwise be excluded. Those "disqualified persons" are certain retailers and refiners as defined in §§ 613A(d)(2) and (4) and any other person whose average daily production of domestic crude oil and natural gas exceeds 500 barrels for its tax year in which the partnership's tax year ends.

The election to deduct intangible drilling and development costs ("IDC") is still made at the partnership level. However, since the new provisions treat those taxpayers required by Code § 291 to capitalize 30-percent of IDCs as disqualified persons, an oil and gas electing large partnership may pass through a full deduction of IDCs to its partners who are not "disqualified persons" as defined above. The electing large oil and gas partnership has the responsibility with respect to its qualified partners for making a Code § 59(e) election to capitalize and amortize certain specified IDCs.

II. Recent Arkansas Legislation

II. Recent Arkansas Legislation -- Registered Limited Liability Partnerships and Registered Limited Liability Limited Partnerships:

During the 1997 regular session, the Arkansas legislature amended the Uniform Partnership Act and the Revised Limited Partnership Act of 1991 to allow for two additional entity types -- registered limited liability partnerships ("RLLP") and registered limited liability limited partnerships ("RLLLP"). The key to these entities is that, unlike general and limited partnerships, ALL partners in an RLLP or RLLLP have limited liability protection. Specifically, the partners in the enterprise are not liable, directly or indirectly, for debts, obligations, liabilities of or chargeable to the partnership arising, whether in tort, contract or otherwise, from errors, omissions, negligence, incompetence, or misconduct committed in the course of the partnership business by another partner or by an employee, agent or representative of the partnership. However, this limitation on the personal liability of a partner does not extend to cover the liability for the partner's own errors, omissions, negligence, incompetence, or misconduct and that of any person under the partner's direct supervision and control. Also worth noting is the fact that a domestic limited partnership may become an RLLLP by complying with the applicable provisions of the Arkansas Revised Limited Partnership Act of 1991, §§ 4-43-101 et seq. These new entity types allow all partners to have the protection of limited liability while maintaining the favorable tax treatment enjoyed by partnerships.

III. Tax Deferred Exchanges

III. Tax Deferred Exchanges: §1031 Exchanges

Section 1001(c) of the Internal Revenue Code states the general rule that all gains and losses shall be recognized upon the sale or exchange of property. However, § 1031 provides a major exception to this rule. It states,

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for the productive use in the trade or business or for investment.

There are several important points to note here:

A. § 1031 does not result in the permanent exclusion of the taxable gain. It is simply a deferral of the recognition of gain until a subsequent sale or disposition of the acquired like kind property.

B. This deferral of gain only applies if the property exchanged was held for productive use in a trade or business or for investment and the property acquired in the exchange is for the productive use in a trade or business or for investment. Therefore, a dealer in the property would not qualify for the non-recognition protection provided by § 1031.

C. Six categories of property have specifically been identified as not falling under the non-recognition rule for like kind exchanges. They are:

(1) stock in trade or other property held primarily for sale;
(2) stocks, bonds, or notes;
(3) other securities or evidences of indebtedness or interest;
(4) interests in a partnership;
(5) certificates of trust or beneficial interests, or
(6) choses in action.

D. The non-recognition principal in § 1031(a)(1) does not apply to any exchange of interests in a partnership regardless of whether the interests exchanged are general or limited partnership interests or are interests in the same partnership or a different partnership.

E. No gain or loss is recognized if like kind property is exchanged solely for like kind property. However, if property other than qualifying property is received in the exchange, then some portion of a gain (but not a loss) realized with respect to the relinquished property will be recognized.

F. There are special rules for exchanges between those who meet the definition of "related persons" and generally, the non-recognition of gain will not apply to exchanges between related parties if either of the parties disposes of the exchanged property within two years.

The immediate question presented here is what is "like kind" property? Do you have to trade an automobile for an automobile? farm land for farm land? commercial real property for commercial real property? Generally, the answer to these questions is no. However, the IRS is much more stringent on exchanges relating to personal property.

The term "like kind" as used in § 1031 refers to the nature and character of the property, not the quality or grade. In fact, the Regulations give the following illustrations of like kind real property exchanges: a person who is not a dealer in real estate exchanges city real estate for a ranch or farm; or exchanges a leasehold of a fee with 30 years or more to run for real estate; or exchanges improved real estate for unimproved real estate. All of these qualify as like kind property exchanges.

When considering exchanges of natural resources, you must first look to state law to determine the "nature" of the legal interest which you have in the property. The federal taxing statute designates what interests or rights created by state law shall be taxed. The mere fact that two properties are both real property is not enough for the exchange to qualify as "like kind". The rights in the properties must be similar. For example, A Corporation transferred carved-out oil payments for a fee interest in realty. This did not qualify for like kind treatment even though applicable state law classified oil payment rights as real property because the oil payment rights were of limited duration. B Corporation transferred a leasehold interest in oil-producing lands to other oil companies in exchange for the right to an undivided 5% interest in the oil produced by the other companies, up to a maximum of 400,000 barrels. The property interests were not of a like kind because the property transferred was a continuing interest, while the property received was limited. A final example is one in which C Corporation exchanged an overriding royalty interest in minerals for a city lot. Because the royalty interest was a real property interest under state law, and the interest in the lot was a continuing interest, there was a like kind exchange.

What if you have located the property that you would like to exchange, however, the owner only wants cash? For example, you own a farm in Iowa which you are wanting to exchange for a small apartment complex in Texas which is owned by Ted. The problem is that Ted only wants cash for his apartment complex, and definitely is not interested in your farm in Iowa. While Ted may not want your farm, Bob, the property owner adjacent to your farm, is interested in purchasing your farm for cash, but this would result in a large capital gain tax to you upon the sale. The following illustrates the problem:

Is there any solution which gets all three parties what they want? Yes. This transaction is commonly referred to as a "three corner transaction" and is a relatively simple means of getting all three parties what they want with no current tax recognition to you so long as all parties to the transaction are identified. Here is how it works:

1. You exchange your farm for Ted's apartment complex which gets you the property you want at no currently recognizable gain; and
2. Bob then purchases the farm from Ted which gets Ted the cash he wanted and Bob the farm he wanted.

This transaction will not always work because Ted may object to being considered a legal owner of the property he acquires in the exchange (even if it was for a very short period of time) prior to his sell to Bob. (One obvious reason that Ted would object to being in the chain of title to the real property relates to environmental concerns. The mere presence of hazardous wastes on the property will require a due diligence review before this should be considered!)

What happens if Ted refuses to participate in the three corner transaction? We add an intermediary to the process, and instead of having a three corner transaction, we have a "four corner transaction." The four corner transaction works like this:

1. You transfer your farm to an intermediary.
2. Bob then purchases your farm from the intermediary for cash.
3. The intermediary then buys Ted's apartment complex with the cash it received from Bob.
4. Lastly, in return for your transferring the farm to the intermediary, the intermediary now transfers the apartment complex to you.

Everyone ends up getting the property (or cash, as the case may be) that they wanted. The four corner transaction presents another potential trap for the unwary. The intermediary in the example above was simply your agent. It was involved in the transaction solely for you to get the preferred tax treatment allowed in § 1031 for deferral of gain. Therefore, it is very possible that you could run into problems of "constructive receipt" which would blow the § 1031 nonrecognition of gain for you because you would be treated as having received cash in the deal. However, the regulations state that if you use a "qualified intermediary" in a simultaneous exchange, the qualified intermediary will not be considered the agent of one of the parties for purposes of § 1031. Who meets the definition of a qualified intermediary? It is defined as a person who is not the taxpayer or someone who is a "disqualified person" and who enters into a written agreement (the "exchange agreement") and acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. A "disqualified person" is defined as a person who has acted as the taxpayer's employee, attorney, accountant, investment banker or broker or real estate agent or broker within a specified time period or a person who is a "related party" under specific sections of the Code. The use of a qualified intermediary is advised to avoid the possible invalidation of a § 1031 exchange. (There are numerous companies which are in the business of acting as a qualified intermediary for § 1031 exchanges.)

What if you want to enter into a § 1031 exchange, but you have not yet identified the property that you want to receive in the transaction? Take the illustration above. You own the farm in Iowa and really want to get rid of this investment. Bob has offered to buy the farm, but you would have to recognize a large capital gain tax. 

Can a § 1031 exchange be done here? In other words, is there such a thing as a "deferred exchange"? The answer is yes. The nonrecognition rules of § 1031 may apply even if property is relinquished in an exchange at a different time than the new property is received. However, the exchange will not be treated as an exchange of like kind property if:

1. The property is not identified as property to be received by the taxpayer on or before 45 days after the taxpayer transfers the property relinquished in the exchange (also known as the "identification period"); or
2. The property is received more than 180 days after the taxpayer transfers the property relinquished in the exchange (or if it is received after the date the taxpayer's income tax return for the year in which the exchange occurred is due -- whichever is earlier) (also known as the "exchange period").

What if your 45 days in which to identify the property you want to received in the transaction is almost up, and you have not specifically identified the property you want? What can you do? It is permissible to give a list of potential property that will serve as your replacement property. You may identify more than one replacement property, but additional rules apply. Regardless of the number of properties you transferred as part of the deferred exchange, the maximum number of replacement properties that you may identify is (a) three properties without regard to the fair market value of the properties (known as the "3-property rule"), or (b) any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200% of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by you (known as the "200-percent rule").

This presents a brief introduction to the § 1031 like kind exchange, however, there are numerous factors to consider when looking at this type of exchange. For example, assumption of mortgage(s), basis in the property received, etc. Numerous rules apply and must be taken into consideration. This introduction to the § 1031 was to simply alert you to the fact that it exists and that you may want to give it consideration when looking at transactions in which it might be utilized.

IV. Estate Planning Issues

A. Taxpayer Relief Act of 1997

The passage of the Taxpayer Relief Act of 1997 saw the enactment of several provisions in the Code which will assist the taxpayer in transferring assets to others with either no costs or lower costs than prior to the Act's passage. The following items are of particular significance:

1. Unified Credit:

Prior to the passage of the Act, § 2010(a) provided the general rule that a credit of $192,800 (equivalent to the estate tax on an estate with assets valued at $600,000) shall be allowed to each estate against the tax imposed under § 2001.51 That has now changed. In the year 2006, a decedent dying and/or a donor making gifts, shall be able to pass assets valued at $1,000,000 estate and gift tax free. However, prior to that time, there is a phrase in of the applicable exclusion amount. It is as follows:

It is easier today than ever before for middle income America to accumulate assets valued at or in excess of the $625,000 applicable exclusion amount due to the appreciation of real property and the ability of taxpayers to save pre-tax money in the form of retirement plans. People are generally surprised when they begin the estate planning process to see the "value" of their assets. Therefore, this should provide some relief to middle income taxpayers by completely eliminating the estate and/or gift tax to those who were in the lower brackets of the tax rate schedule.

2. Qualified Family Owned Business:

The Act provides an additional exclusion from the estate tax if the decedent was a qualified owner in a closely-held business and meets certain requirements. If an estate qualifies, there is excluded from a decedent's gross estate, the LESSER of:

1. the adjusted value of the decedent's qualified family-owned business interest, or
2. the excess of $1,300,000 over the applicable exclusion amount in effect with respect to the decedent's estate.

In general, to qualify for the exclusion, the aggregate value of the decedent's qualified family-owned business interests that are passed to qualified heirs must exceed 50 percent of the decedent's adjusted gross estate; the decedent must be a U.S. citizen; and the executor of the decedent's estate must make a special election for this type of tax treatment and must file a recapture agreement signed by each person having an interest in the property. Further detail on these requirements follows.

a. Ownership Requirement --

A qualified family-owned business is any interest in a trade or business with a principal place of business in the United States, the ownership of which is held (a) at least 50% by one family, (b) 70% by two families, or (3) 90% by three families. If held by more than one family, the decedent's family must own at least 30% of the trade or business. Members of the decedent's family include (1) the individual's spouse, (2) the individual's ancestors, (3) lineal descendants of the individual, of the individual's spouse, or of the individual's parents, and (4) the spouse's of any such lineal descendants.

b. Valuation --

The value of a trade or business qualifying as a family-owned business interest is reduced to the extent that the business holds certain passive assets or cash and marketable securities in excess of the reasonably expected day-to-day working capital needs for the trade or business. For non-dealers in these assets, the following assets are considered passive assets and, therefore, are not included in the value of a qualified family-owned business:

1. assets that produce dividends, interest, rents, royalties, annuities and Code § 543(a) personal holding company income;
2. assets that are interests in a trust, partnership or real estate mortgage investment conduit (REMIC);
3. assets that produce no income;
4. assets that give rise to income from commodities transactions or foreign currency gains;
5. assets that produce income equivalent to interest; and
6. assets that produce income from notional principal contracts or payments in lieu of dividends.

c. Qualifying Estates --

In order to qualify for this tax exclusion, the decedent must have been a U.S. citizen or resident at the time of death and the aggregate value of the decedent's qualified family-owned business interests that are passed to qualified heirs must EXCEED 50% of the decedent's adjusted gross estate. The term "qualified heirs" includes members of the decedent's family as well as any individual who was actively employed by the business for at least 10 years prior to the date of the decedent's death. The decedent's qualified family-owned business interests passing to qualified heirs includes lifetime gifts of such interest made by the decedent to members of the decedent's family to the extent that those interest are held by family members between the date of the gift and the date of the decedent's death. There is a special 50% liquidity test which is done to determine if this requirement is met.

d. Participation Requirements --

The decedent, or members of the decedent's family, must have owned and materially participated in the trade or business for at least 5 of the 8 years preceding the decedent's death in order to qualify for this special treatment. In addition, a qualified heir is subject to a recapture tax if the heir or a member of the qualified heir's family does not materially participate in the business for at least 5 years of any 8 year period within 10 years following the decedent's death.

3. Cost-of-living Adjustments for the Annual Exclusion --

Section 2503(b) allows a person to make a gift of up to $10,000 per person per year without having to pay any gift tax. This is called the "annual exclusion". Under the revisions enacted in the Act, this amount will be indexed annually for inflation after 1998. This should provide some tax relief in the future if you consider that the annual exclusion has been $10,000 since 1981 when it was increased from $3,000 effective for transfers made after December 31, 1981.

B. Estate Planning Basics:

Typically, individuals develop an estate plan for two reasons: (1) primarily to determine the disposition of their property upon death; and (2) to minimize the costs of getting those assets to their beneficiaries. The starting point of any estate plan should be to ask, "If there were no taxes involved, who would I give my assets to?" This establishes the cornerstone for the building of your estate plan. Once that question is answered, you then consider the tax consequences involved in making the dispositions desired. The rest of this discussion will assume that we are dealing with an estate which would incur gift/estate tax upon disposition of property whether through gifts during lifetime or at death.

Obviously, there are two times transfers of property may be made:

1. Transfers of property during lifetime, and
2. Transfers of property at death.

These transfers will be discussed separately since different rules apply to each even though the Tax Code encompasses a unified tax rate for both types of transfers.

1. Lifetime Transfers --

During life, you have the opportunity to continuously evaluate your estate plan. This provides you with much needed flexibility to make adjustments as the size and value of your estate fluctuate as well as to take into consideration changes in the tax laws. When you have determined that you need or want to make gifts, there are two basic rules to keep in mind:

Basic Rule #1: Do not select property which has a low basis, i.e., it has already appreciated in value.

The reason for this rule is that when you make a gift to someone ("donee"), the donee will get the same basis in the property which you, the "donor", had prior to making the gift. For example, you own real property with a cost basis of $50,000, but it has a current fair market value of $100,000. If you were to sell this property, you would have to recognize a gain of $50,000 ($100,000 sales price - $50,000 cost basis = $50,000 gain). If you were to give this property to a donee, the donee's basis in the property would be $50,000, therefore, the donee already has unrecognized gain of $50,000 on the property he/she just received as a gift. If you were to give this property upon your death, the person receiving it would get a "step-up" in basis in the property to the fair market value as of your date of death. In this example, he/she would have a new basis in the property of $100,000, and if sold immediately, would not have to recognize any gain in the property.

If you were to follow this rule, you would not want to make lifetime gifts of producing properties since they are wasting assets which have already appreciated in value and, in most cases, have a low basis. However, nonproducing properties are suitable for lifetime gifting because they are subject to substantial future appreciation if production is later achieved. You would want to select unproductive property which has yet to realize its potential. This results in getting the future appreciation of the property out of your estate, and at the time of the gift, the value of the property was relatively low which kept your gift tax to a minimum. When looking at gifting mineral interests, a good gift would be royalty or over-riding royalty interests.

Basic Rule #2: Do not give property which has decreased in value so that you have a loss on the property if it were sold for fair market value.

The reason for this is that while you could take a loss on the property if it were sold, the donee would not be able to take the loss. If you gift loss property, the donee gets a basis in the property at its fair market value as of the date of the gift, therefore, the loss which the donor had is lost forever. No one benefited from it. For example, you own property with a fair market value of $10,000, but you paid $15,000 cash for it when it was purchased 3 years ago. You would not want to make a gift of this property to anyone because the donee of the property would take a basis of $10,000 instead of your basis of $15,000. For tax planning purposes, the best thing to do would be for you to sell the property, take the loss and then make a gift of the money from the sale of the property to the donee.

One of the most difficult problems encountered in gifting of mineral interest is establishing the value of the gift if you have unproductive property. This is definitely subject to question by the IRS. However, some comfort may be taken from the recent enactment of the Taxpayer Relief Act of 1997 in that the IRS may no longer revalue an adequately disclosed gift for which the 3 year statute of limitations period has expired to determine the donor's estate tax liability.

There are three important tools to remember and take advantage of when establishing a gifting program, two of which were mentioned previously:

1. Section 2503(b) allows a person to make a gift of up to $10,000 per person per year without having to pay any gift tax. This is referred to as the "annual exclusion."
2. If both spouses join in the gift, they can give up to $20,000 per person per year. This is true even if the spouse joining in the gift owns no interest in the property being gifted.
3. Section 2503(e) allows you to make payment on behalf of someone for certain educational and/or medical expenses directly to the provider without that payment being considered as a gift (nor does it use your annual exclusion gift for that person).

In beginning any gifting program, you should consider taking advantage of the annual exclusion gift as well as possibly paying certain educational expenses for children or grandchildren.

Now that the basic rules of lifetime gifting are understood and you know the tools which you can utilize, you must determine the form that the gift is to take -- (1) outright gift to the donee or (2) gift to a trust for the benefit of the trust beneficiary.

A. Outright gift --

This form of gift is where you transfer or convey ownership directly to the donee. Benefits to this form of gift-giving are that the person you want to have the gift gets it immediately upon transfer giving you the opportunity to see the person enjoy your gift during your lifetime. There are no problems encountered with trust administration or accounting issues relating to the income and/or expenses incurred by the gift. However, if you have a person who is incapacitated due to age or any other factor (mental, physical, etc.), then this form of gift may not be the wisest choice. Once you have determined that you wish to make an outright gift to the donee, then consider which types of mineral, royalty, or over-riding royalty interests make the best gifts.

If you make a gift of your working interest, you would lose the right to deduct current operating charges and depreciation. In the alternative, if you give an overriding royalty on undeveloped leases as a gift, the burden of the override reduces your future income, but the donee of the overriding royalty does not have to contend with the management of the interests nor to the expenses and risks borne by the working interests owners.

Another possibility for gifting is the production payment. These do not extend over the life of the property, but are limited as to value, term or production. There are two types -- (1) retained production payment, and (2) carved out production payment. A retained production payment is one which is reserved out of an assignment of oil and gas properties. A carved out production payment is one which was assigned out of a larger retained interest. If you give a gift of a retained production payment to a donee, income from the production payment will be taxable income to the donee. However, if you give a gift by assigning to a donee a production payment which is carved out of a larger interest which you still own, the gift will be treated as an assignment of income, and you will remain taxable on the income from the production payment. There are numerous problems raised if you make a gift to a donee but retain a production payment out of the mineral interest transferred, however, these are beyond the scope of this paper. You should seek legal advice before this course of gifting is taken.

B. Gift to a Trust --

If an outright gift is not the form chosen, then you may make a gift to a trust. There are many advantages to making a gift in trust for the benefit of a beneficiary. The advantages include the fact that you select the trustee of the trust which means you can ensure the trustee has the management qualifications needed to operate the properties compromising the trust corpus; you can provide a tremendous amount of flexibility in the trust as well as duties and rights of the trustee so that invasions of corpus can be made, if necessary, for the benefit of the beneficiary; you can protect the assets of the trust from attachment by creditors (assuming you are not the beneficiary of the trust); and you can protect the assets from becoming marital property subject to rights by a divorcing spouse of the beneficiary. There are two broad classifications of trust which will be discussed here -- (a) Revocable Trust, and (b) Irrevocable Trust.

a. Revocable Trust --

A revocable trust is one in which you transfer property, but you retain the right to alter, amend or revoke the trust in whole or in part. Today, revocable trusts are an integral part of many estate plans due to the benefits associated with these types of trusts. It is an extremely flexible instrument and allows the Settlor (person creating the trust) to alter or amend it as the Settlor's circumstances change. Additional benefits are that it allows the Settlor the opportunity to have the assets of his/her will pour over into the trust, avoid probate if all assets are owned by the trust and to maintain privacy of the trust provisions since it does not have to be filed in the public record of the Court.

It is important to note that a revocable trust provides no estate tax planning relief for the Settlor. The value of the assets in a revocable trust will be included as part of the Settlor's gross estate upon death, therefore, there are no estate tax benefits to placing assets in this type of trust.

b. Irrevocable Trust --

An irrevocable trust is one that once created, it cannot be altered, amended or revoked by the Settlor. Assuming that the Settlor is not a beneficiary under the trust and does not maintain control over certain aspects of the trust which would result in bringing these assets back in to the Settlor's gross estate, an irrevocable trust will divert the value of the assets in the trust and the income generated by these assets out of the gross estate of the Settlor upon death. The Settlor may avoid estate tax as well as income tax with respect to property used to fund an irrevocable trust. These type of trusts are ideal for gifting to children and grandchildren, however, you must be conscious of the fact that once you have made gifts to an irrevocable trust, you have given up all control of the gift and its eventual distribution to the beneficiary.

There are numerous traps to be wary of when making a gift to a trust. First, only property in which the beneficiary has a present interest will qualify for the present interest annual exclusion. An exception to this is provided by § 2503(c) which states that a gift in trust for a minor where the principal and all accumulated income may be expended by or on behalf of the donee, and to the extent not expended on the donee's behalf, paid to the donee at age twenty-one, will qualify for the annual exclusion exception. Second, you want to give the trustee of the trust specific authorization to retain producing oil and gas interests since these are considered wasting assets. This means that you should include the authority for the trustee to enter into oil and gas leases, farm-out agreements, the power to borrow money for the benefit of the trust, etc.

C. Charitable Gift --

The last item to be touched on in the lifetime gifting section is gifts to charities. If you are charitably inclined, then a gift to a favorite charity during your lifetime will reap you multiple rewards -- (1) you get a current income tax deduction for the charitable gift in the year in which the gift is made; (2) you remove assets from your estate so that upon your death the value of your gross estate is lower; and (3) you get the recognition by the charitable organization and your community during your lifetime.

You need to be cautious when selecting assets to be given to a qualified charity (being one which qualifies for special tax treatment under § 501(c)(3) of the Code). For example, a qualified charity cannot accept a working interest because of the imposition of tax on unrelated business income.

2. Transfers at Death --

At death, property is transmitted in the following ways:

• By will;
• By intestate succession;
• By a surviving spouse's claim of dower, curtesy or homestead;
• By operation of law such as that with property owned in joint tenancy with right of survivorship or by tenants by the entirety; and
• By contract such as that where you have named a beneficiary of your insurance policy, IRA or other retirement plan.

A. Testate versus Intestate:

It has been said that:

It is a common fallacy to believe there is a freedom of choice to have or not to have an estate plan. Knowingly or not, every person has an estate plan. For those persons who do not leave a will, the Legislature has imposed its plan through the law of intestate succession. As a result, the choice is whether the individual will design his own plan in light of his own family needs or whether he will accept by default the Legislature's scheme of property disposition.

You either designate who you want to get your property upon your death by the use of a will or trust, or you accept the distribution provided in the Arkansas law of descent and distribution.

You may be surprised by the distribution made under Arkansas law if you choose to die without making prior provisions for distribution of your property. For example, if you die without a will/trust, and you are married with descendants, your spouse will only be entitled to dower/curtesy rights in the property. If you died owning land, your spouse's dower or curtesy right would be a one-third life estate in the property. However, if there are no descendants, then your spouse would get a one-half fee simple interest in the land. Since mineral interests constitute an interest in real property under Arkansas law, you might think that the same rule applies but it does not. There is a specific statute which provides that the surviving spouse is entitled, absolutely and in his or her own right, to one-third of all money received from the sale of oil and gas or other mineral leases, oil and gas or other mineral royalty or mineral sales, and to one-third of the money derived from any and all royalty run to the credit of the royalty owners from any oil or gas well or to royalty accruing from the production of other mines or minerals in lands in which he/she has a dower/curtesy interest. These distributions, typically, are not representative of the distribution a person would make of his/her estate.

Not only do you not have the distribution you want, you also encounter numerous other problems associated with intestacy. Such difficulties include property passing in outright ownership regardless of the age or competency of the heir; the necessity of guardianships for minor heirs, etc. Therefore, a will or other instrument will probably be deemed to be needed.

B. Marital Deduction --

If you are married, then upon the death of the first spouse, it is possible to pass an estate of unlimited size and value to the surviving spouse (assuming that all assets qualify for this deduction). This is referred to as the "marital deduction." Again, there are numerous rules and exceptions which apply to the marital deduction. For example, assets which lapse after a specified time or upon occurrence of an event or contingency (life estates or terminal interests), do not qualify for the marital deduction. Or if the surviving spouse is not a U.S. citizen, then the marital deduction is not allowed. The bulk of assets owned, however, are generally covered by the marital deduction.

For tax planning purposes, assuming all assets qualify for the marital deduction, you would not want to pass your entire estate under the marital deduction. Why? Because you have not taken advantage of the unified credit to shield assets from future estate tax in the surviving spouse's estate upon his/her death. This can best be illustrated by the following examples.

Example #1: 100% Marital Deduction

Value of Assets

You $1,000,000
Spouse $ 700,000

Assume that all assets qualify for the marital deduction. You die before your spouse and leave everything outright to your surviving spouse. No estate tax is due at your death, but you have just increased the value of your spouse's estate to $1,700,000 from the $700,000 he/she owned individually and did not shield the current unified credit amount of $625,000 from future estate tax. Estate tax due at your spouse's death would be approximately $443,750.

Example #2: Minimum Marital Deduction with use of the Unified Credit

Assume the same facts as above, except you do not give everything outright to your surviving spouse. Instead, you give your spouse the minimum amount you can to avoid estate tax. This would mean that at your death, your spouse would get $375,000 and $625,000 would be used to either fund a unified credit trust for your spouse's benefit during his/her lifetime or given outright to other than your spouse. Now, your spouse's estate is $1,075,000 instead of the $1,700,000 in Example #1. Under this scenario, there is still no estate tax due at your death. However, the amount of estate tax due at your spouse's death would be $174,500.

The use of the minimum marital deduction with use of the unified credit saves a total of $269,250 in estate taxes ($443,750 - $174,500). The importance of the marital deduction cannot be overlooked, however, it is a tool which is only available for planning purposes when both spouses are alive. It should also be pointed out that the automatic use of the marital deduction in every estate plan is not recommended when both spouses have taxable estates and you are looking at the total estate taxes due upon the death of both spouses. This is beyond the scope of the introductory purpose of this paper and will not be covered.

V. Conclusion

The year 1997 brought many changes to the tax laws. Some which benefit taxpayers and some which make it more difficult for taxpayers to take advantage of beneficial provisions in the Code. In this ever changing environment, it becomes imperative that you keep abreast of the changes to enable you to make adjustments to your businesses, investments and estate plan as needed. If you do not have an estate plan, then get one. You are in the driver's seat and have the choice of whether to develop your own plan or to accept the default plan provided to you by the government. The responsibility is yours.

DUNN, NUTTER, & MORGAN, L.L.P.
-- ATTORNEYS AT LAW--
Practicing in Texas & Arkansas

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Texarkana, TX 75503-0716
Phone (903) 793-5651
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