Dear Michael: My parents had quite a few minerals and when my father died, I received some of these minerals. When my mother died, she left her minerals to my children (all of her grandchildren) but I received a life estate in the minerals. I don't have to worry about these minerals being included in my estate for tax purposes being as Mom bypassed me for ownership, right? I only get the income and my kids own the minerals.
– Passed By On Ownership
Dear 'Passed By':
I am sure your mother was well-intentioned when she gave the minerals to your children and gave you a life estate in the property. However, IRS has a rule that anything you have the right to receive all the income from under a life estate status will be included in your estate at it's fair market value at the time of your death for estate tax purposes.
Therefore, when you die, the minerals will be appraised at their market value at that time – which could be a problem if your mineral interests rise in value – just as if you had owned the minerals outright.
In her effort to keep the mineral ownership within her bloodline, Mom may have inadvertently created an estate tax monster.
The same might be true for people who have given mineral away but kept a 'royalty deed'. Many people got advice a few years ago that's ultimately turned out to be bad advice in the long run. It wasn't bad advice at the time, but no one knew how large all of this oil was going to grow into.
The really bad thing is when people assume the advice they received in 2005 through 2010 is still viable advice. This is only true for those people who were passed by in the oil boom or had negligible income.
For those people who have income producing wells, they may only be seeing the tip of the iceberg right now. Each well head is capable of multiple legs. The first go-round of drilling was just to make certain there was a hole in the ground for each spacing unit so oil companies wouldn't have go through leasing the property all over again. This, for the most part, has been completed.
The next stage is to run multiple legs off of the existing well-heads – with the infrastructure that's now in place – and draw even more oil with the fracking.
Fracking isn't like drilling pools, as they might do in Texas or Saudi Arabia. Fracking only goes in one direction, per se, and only so many feet side to side in that direction. Unlike pool drilling, where you eventually drain the pool off of one wellhead, each additional leg in fracking can produce more and more income.
What this means is for many people who are using advice from when they only had one leg on their wellhead, they've probably got outdated advice – as was the case with your mother.
Don't worry, there's a lot of people in the same boat. They thought they'd seen the lawyer once and that should be good enough.
Luckily for you, you thought to inquire. You can use a combination of gifting and discount methods to reduce the future estate tax load. You can use an LLC or an LLP or simply gift your life estate interest in your minerals to your children today. Don't forget, IRS lifted the limitations on gifting to grandchildren now, so you can also do generation skipping gifts now without the old five thousand dollar limitation.
The future is quite simply this: Those who have good wellheads now – and good income – are likely to see more and more development on those same wellheads – and with it an almost certainty of paying estate taxes in the future due if you don't update your planning. Get ahead of the curve for a change and do what's necessary now before this almost certain growth occurs in the future.