Ownership of Mineral Interests

New technology has made the Bakken shale in North Dakota/Montana and Marcellus shale in the Northeast very valuable mineral interests. Many donors with new-found wealth now have a greater interest in charitable giving. But how should they give? What are the rules? Should the gift be outright or in trust? Who is a qualified appraiser?

The owner of a mineral interest has the right to exploit, mine and/or produce any or all of the minerals lying below the surface of the property. The varying degrees of ownership make gifts of oil and gas interests to charity complex. Some donors own land with oil or gas deposits while others own only the mineral rights. Both types of owners may lease their mineral interests to an energy company that will extract the minerals in exchange for royalty payments. Oil and gas interests are transferred to charity by deed or, in the case of a testamentary transfer, by will.

Donor Owns Land with Minerals

If the donor owns the land with oil or gas under the surface, the donor cannot contribute less than the donor's entire interest. Contributions of partial interests in property are not deductible. Sec. 170(f)(3)(A). However, under an exception to the partial interest rule, a deduction is permitted for a gift of an undivided portion of a donor's entire interest in the property. Sec. 170(f)(3)(B)(ii). The donor must gift the land together with the minerals (oil or gas) to permit a charitable deduction.

The donor must own the interest for more than one year to take a deduction based on fair market value. Sec. 170(e). If the fair market value of the interest is $500 or more, Form 8283 must be included with the donor's tax return to permit a charitable deduction. The gift of an interest over $5,000 in value will require a qualified appraisal, otherwise the charitable deduction may be denied. Reg. 1.170A-13(c).

The gift of land with oil or gas under the surface may be made outright to charity or to fund a life income arrangement, such as a charitable remainder trust (CRT) or charitable gift annuity (CGA). See CRT and CGA Transfers below for information on how to handle life income gifts funded with oil and gas interests.

Donor Owns Only Mineral Interest

If the donor only owns the mineral interest, the donor can gift the minerals alone to charity or to a charitable trust. Because the donor is gifting his or her entire ownership interest, the partial interest rule is not implicated. Sec. 170(f)(3)(A).

The deduction is based on fair market value if the interest is held for more than one year. The general rule of thumb in the oil and gas industry is that the value of a mineral interest equals the annual income produced by the interest multiplied times four. The filing of Form 8283 and a qualified appraisal will be required if the property exceeds the thresholds noted above. There may be additional issues for life income gifts.

Donor Leases Mineral Interest for Royalties

Even if the donor has leased the mineral interest, he or she may assign the royalty stream to charity or fund a CRT. There is no issue of income avoidance because a royalty is not earned income. See Lucas v. Earl, 281 U.S. 111 (1930). Since the royalty payment is assigned, the donor avoids income tax on the payment. While there are no specific cases on point, under the "fruit of the tree" analysis a gift of an ordinary income stream of dividend payments does not produce a charitable deduction. Sec. 170(e)(1).

CRT or CGA Transfer Issues

If the leased interest is transferred to fund a life income plan, it is important to assess whether the royalty payment is sufficient to sustain the desired payout (assuming the interest is retained). Generally a NIMCRUT or FLIP payout works best because the future income stream may be uncertain. Since minerals are a depleting asset, a CGA, which requires a fixed payment, is often a more difficult obligation for the charity to meet.

Note that because royalties are considered passive income, the income is generally not subject to unrelated business income tax (UBIT). Sec. 512(b)(2). In a series of rulings, the IRS has held that the income is not subject to UBIT as long as the royalty interest is not a "working interest" controlled by the charity (i.e. the charity is liable for operational expenses associated with developing the minerals). Rev. Rul. 69-179; PLR 7741004. The IRS has also said that it will not permit charities to characterize income from a working interest as a royalty to avoid UBIT. Rev. Rul. 69-192.

The donor could, of course, receive the royalty payment, pay the taxes that are due and then make a deductible gift of some or all of the cash to charity. A third option is for the donor to transfer the lease to charity or a CRT. Again with this option there is no income paid to the donor, but the gift is also not deductible for federal income tax purposes. The CRT should be established again with a NIMCRUT or FLIP payout if the interest is held in the trust.

Gift Acceptance and Environmental Concerns

If you have donors who are interested in making gifts of land with oil and gas interests, consider reviewing and updating your gift acceptance policies. Ideally, you should establish minimum gift values you are willing to accept. With real estate, where there is the potential for hazards, always make sure to conduct an environmental inspection. GiftLaw Chapter 5.2 provides further information on gift acceptance policies and an environmental inspection checklist.