Marcellus Shale comes with many Rewards and Risks

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Landman

• First point of contact for the Landowner• Independent contractor• Commission earned based on amount of

acreage leased• Presents standard lease to Landowner

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Lease

• In short, the legal right to drill for and produce oil and gas. There is no such thing as a standard lease form. All terms are negotiable.

• Lessor must sign• Recording • Termination issues

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Lease Addendums

• Landowner draws up• Landowner’s demands• Can be few or many• Needs to be agreed upon by Exploration

Company

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Negotiation Issues - Lessor and Lessee

• Lessor: Mineral rights ownerWill want to protectWell distance from homes, school, etcCrops, livestockExisting water wells

• Lessee: Typically an oil or gas companyWill want rights toExplore, survey, drill, lay pipelinesBuilding roads and facilities (like a storage tank)

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Ownership Issues

• Specialized Title Search

• Minerals vs. Oil & Gas

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Details of Standard Oil and Gas Lease

• Term of the lease• Pooling• Ownership change• Surface use• Storage• Regulations and delays• Operating royalty payment

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Terms of Lease

• Paid-up lease • Primary term• Secondary term option• Bonus royalty paid at beginning of each term • If lease expires without being in a unit,

landowner can sign with another exploration company

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Pooling

• Amount of land required for a unit

• Minimum of 80 acres

• Maximum of 640 acres

• One owner or many owners

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Ownership Change

• Both parties can assign their rights

• Must notify remaining party timely

• Family owned LLC

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Surface Use

• No well within 200 feet of residence or structure

• Can extend distance through addendum

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Storage

• Exploration company right

• Can store natural gas on landowner’s property

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Regulations and Delays

• Lease will not be terminated

• Additional time added to term of lease

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Operating Royalty Payment

• Minimum Royalty – 1/8th• Paid monthly• Could last for 30 years• Based on four factors:

Amount of cubic feet of natural gas extracted at the wellheadx

Average monthly price of natural gasx

Landowner’s ownership % in the unit x

Royalty % in the lease agreement

(Ex*: 416,781 cu/ft x $3.97 x .0185196 x 16% = $4,902.87)

*in thousands

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After Signing

• Bonus Royalty received within 60 days

… then the waiting period begins

• Wait period could last 5 years

• Activity may take place during this time

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Tax Issues

A Landowner’s Perspective

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Sources of Income

• Bonus income• Operating royalty• Pad fee• Shut in fee• Right of way income• Timber income• Staging area fees• Facility reception point and compressor station

fee

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Bonus and Operating Royalties

• Bonus: Taxed as rental incomeSubject to passive activity rulesOne-time payment upon signing leaseDepletion is not allowed

• Operating: Taxed as royalty/ordinary incomeSubject to depletionPayment received monthly

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What is Depletion?

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Pad and Shut In Fees

• Pad: Income may or may not be taxableReduction of basisOne-time payment

• Shut In (Consideration for period when gas is not marketed from well capable of production):

Taxable as rental incomeSubject to passive activity rulesPaid annually

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Right of Way

• Can be taxable or non-taxable

• Taxable: Received as a payment for income

• Non-taxable: Received as payment for damages

• One-time payment

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Easements/Right of Way

• You granted a right-of-way for a gas pipeline through your property for $10,000. Only a specific part of your farmland was affected. You reserved the right to continue farming the surface land after the pipe was laid.

• If the payment is less than the basis properly allocated to the part of your land affected by the right-of-way, reduce the basis by $10,000.

• If the payment is equal to or more than the basis of the affected part of your land, reduce the basis to zero and the rest, if any, is gain from a sale. The gain is reported on Form 4797 and is treated as section 1231 gain if you held the land for more than 1 year.

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Timber and Staging Incomes

• Timber: Income received may or may not be taxablePayment generally is for damages to landReduction of basisOne-time payment

• Staging Area: Taxed as rental incomeSubject to passive activity rulesOne-time payment

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Facility Reception Point (FRP) and Compression Station

• Taxable as rental income

• Subject to passive activity rules

• One-time payment

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Tax Treatment of Other Items

• Delay rentals

• Damages

• Exploration rights

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Delay Rentals - Lessor

• Lease agreements generally provide for the lessee to begin drilling within a certain amount of time. If drilling is not started, the lease agreement may provide for a payment in order for the lessee to retain the lease.

• These payments are known as “delay rentals.”

• Delay rentals received are ordinary income to the recipient, not subject to depletion.

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Damages

• Payments made to the landowner by the oil or gas operator for damages to growing crops, or standing timber.

• Per IRS these payments are ordinary taxable income not subject to depletion.

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Exploration Rights

• Payments made to the landowner by the oil or gas operator for the right to enter the property and conduct exploration activity.

These payments are ordinary taxable income not subject to depletion.

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Lease vs. Sale

WHY IMPORTANT for Tax?

For Lessor:• Lease:

– Ordinary Income• Sale:

– Capital Gain & Adjusted Basis Offset

• Recapture

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Sale

A sale occurs when the owner of any type of mineral interest assigns (transfers) all of his interest and retains no continuing interest.

Gain or Loss can be:• Ordinary or Capital• Capital but taxed as ordinary under §1231, §1245 or

§1254

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Estate, Gift and Inheritance

Tax Considerations

&

Valuation Issues

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Reasons for Estate, Gift and Inheritance Tax Planning

• Reduce death taxes• Protect assets from divorce and other creditors• Nursing home – Medicaid qualification• Preserve asset value• Transfer assets to heirs

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Estate and Gift Tax Exclusions

• $5 Million in 2011 and 2012

• Unless further legislation is passed exclusion will revert to pre-2011 amount of $1 Million

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Property Estates Can Be Owned Separately

• Surface can be owned by Mom & Dad

• Sub-surface can be owned by another entity

• Rights to income can be assigned

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Severance of Oil and Gas Rights

• Until severed – belongs to owner of the surface of the land

• Transfer of land surface by deed prior to severance very effective to transfer gas interests before reserves established

• Land values are low prior to confirmed discovery and procurement

• Post transfer appreciation escapes federal estate tax

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Passing Sub-surface Rights to Next Generation

• Will• LLC – Limited Liability Company• LP – Limited Partnership (No PA Capital Stock Tax)• FLP - Limited Partnership (PA) (No PA Capital Stock

Tax and Favorable Federal Estate Tax Considerations)

• Deed• Trust• Life Estate Deed

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Concerns with Use of Family LimitedPartnerships with Royalties

1. Must have proper establishment of Partnership

2. Possible recapture of certain transactions before death into decedent’s estate

(retained rights that do not end before death)

3. Working vs. non-working interests

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Valuation – First Step

Identify the property interest being transferred

• Surface rights

• Right of support

• Mineral or oil and gas rights – royalties etc.

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What is Fair Market Value?

As defined by the IRS:

“…the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the facts.”

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IRS Statements on Valuation Methods

• Treas. Regs. provides for the priorities of methods to be used to determine FMV.

• Treas. Regs. provides that an analytical appraisal (PV Method) will not be used in either one of the following situations:

• If the value of the property can be determined based on cost or comparative values and replacement value of equipment.

• If the FMV can be reasonably determined by any other method.

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IRS Statements on Valuation Methods

However, Treas. Regs. 1.611-2(c)(4) says:

• The value of each mineral deposit is measured by the expected gross income less the estimated operating expenses.

• Reduced to present value as of the date for which the valuation is made, at the rate of interest commensurate with the risk for the operating life.

• Further reduced by the value of the improvements and capital additions, if any, necessary to realize the profit.

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Valuation - Income Approach

Primary method used to value income generating assets.

Why???

• The oil and gas estate is owned and exploited to generate an income stream.

• Potential income generated from the producing well is the reason why the gas has value.

• Royalties generated from the exploitation of the oil and gas reserves is income benefiting the owner of the mineral estate.

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Sub-surface Rights Decrease Property Value if Separate

• Right of ingress, egress and regress• Build Road• Build Drilling Pad• Build Pipelines

• Limited use and enjoyment decrease usable acreage

• Decreases fair market value of surface property

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Preproduction Value

• Very speculative

• May be no additional value

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During Production Value

• Still very speculative

• No history in Marcellus of well production decline rate or production life expectancy

• Discount rate• Reflects risks

• Maybe 15% - 30%

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Valuation – Factors to Consider

• Are reserves proven or unproven or probable?• Comparable lease transactions• Annual amount of production• Likelihood of development• Quality of Reserve/Well• Likelihood of full development• Timing/accessibility to market/pipelines• Possible “Wet Gas” reserves • Available rigs – only 1,300 to 1,400 available in continental US)

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State Level Inheritance and Estate Taxes

• PA – Inheritance Tax – varying rates

• Ohio – Estate Tax – varying rates – set to expire in 2013

• West Virginia – no inheritance or estate taxes

• New York – Estate Tax – varying rates

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State Level Valuation of Oil & Gas Rights Pennsylvania

• Pre-production – no value (differs from IRS)(2003 PA Ruling reissued in Aug 2008, states that leasehold interests for oil & gas held by a decedent are subject to PA inheritance tax. However, where no oil or gas existed on the property at the date of the taxpayer’s death, the interests have no ascertainable value for PA inheritance tax purposes.)

• Post-production – standard methods used

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State Level Valuation of Oil &

Gas Rights Other States

• Standard methods used

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Thank you