By: Beatrice E. Wolper, Kelly R. Jasin, and Heidi R. Kemp
At one time, landowners may not have given much thought as to how to structure the inheritance they hoped to leave their children and grandchildren. With oil and gas development, many more landowners are starting to consider how best to leave their oil and gas interests, and ultimately the royalties, to their descendants.
One of the common estate planning techniques is to put the property, often a family farm, in a trust. There are several reasons why trusts are often part of this process. Trusts allow for central management of the property by the Trustee. Trusts protect the assets from divorce and creditors of the beneficiary while the assets are held in the trust. Trusts allow the person creating the trust (the “Grantor”) to dictate how the trust funds may be distributed to the beneficiary – this can be particularly helpful with a special needs beneficiary or a financially irresponsible beneficiary.
Trusts have two components – or buckets. There’s the principal bucket, which is made up of the trust assets, i.e. the real estate, cash, and investments. The income bucket is made up of the income that is generated from the principal assets. A trust document will dictate how income and principal are supposed to be paid out to the beneficiary. Principal is usually only distributed under what is called an ascertainable standard – something like “the Trustee may distribute principal to or for the benefit of the beneficiary for his or her health, education, maintenance, and support.” Income distributions can be mandatory or discretionary. Mandatory means that the income generated is distributed to the beneficiary – no questions asked. Discretionary means distributions are at the Trustee’s discretion much like the principal distributions.
Many landowners say they want their children and/or grandchildren to receive 100% of the income as a mandatory distribution. In other words, “I want them to get the same financial benefit that they would if they owned it outright.” Most people assume that royalty payments from oil and gas are “income” for trust purposes. This may or may not be the case. If the trust document does not say otherwise, the Ohio Uniform Principal and Income Act (“UPIA”) applies. The UPIA states that income generated from oil and gas or other minerals comes into the trust as 10% income and 90% principal. This means that if the trust receives a $10,000 royalty check, $1,000 will go in the income bucket and $9,000 will go in the principal bucket. If the trust has mandatory income distributions and discretionary principal distributions, the beneficiary is only guaranteed to receive $1,000. The other $9,000 could be distributed at the Trustee’s discretion for health, education, maintenance, and support.
It is important to understand that attorneys may draft around the UPIA. In the trust document, it can allocate all royalties as 100% income so that the beneficiary will receive everything they would have received if they owned it outright.
Landowners need to think about several things when setting up a trust that may receive payments on oil, gas, and other minerals.
- Do you want the beneficiaries to receive all of the payments without any oversight?
- How old are the beneficiaries?
- How financially responsible are the beneficiaries?
- Are you concerned about potential divorces or creditors?
One of the other major considerations is income taxes. This is a complicated discussion so this explanation is greatly simplified. Royalty income coming into a trust is 100% income for income tax purposes, regardless of the allocation between the income and principal buckets in the trust. If the royalties are distributed to the beneficiaries, the trust will pass out the income tax consequences of the royalties to the beneficiary such that the beneficiary will pay tax at his or her tax rate. If royalties are retained in the trust and not distributed, the trust will pay tax at the trust tax rates – which are usually much higher than an individual’s tax rates.
So, often landowners putting this kind of property into a trust must balance their concerns about income taxes with their concerns about the beneficiaries. An attorney well versed in estate planning, tax, and oil and gas can help!
