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Marcellus Shale Tax Planning Strategies. Penn State Cooperative Extension. About PICPA. PICPA – Pennsylvania Institute of Certified Public Accountants PICPA is a professional association of more than 20,000 CPAs working together to improve the profession and serve the public interest

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marcellus shale tax planning strategies

Marcellus ShaleTax Planning Strategies

Penn State Cooperative

Extension

about picpa
About PICPA
  • PICPA – Pennsylvania Institute of Certified Public Accountants
  • PICPA is a professional association of more than 20,000 CPAs working together to improve the profession and serve the public interest
  • PICPA’s established its Marcellus Shale Task Force to focus on developing resources and guidance for Pennsylvanians impacted by this emerging and fast growing industry, including
    • Landowners,
    • Businesses and entrepreneurs, and
    • State and local governments
overview of gas lease taxation
Overview of Gas Lease Taxation
  • Income received from gas lease will generally be taxed as ordinary income, including
    • Lease bonus payments
    • Royalty income
    • Crop damage
    • Anticipated damages but none was done
  • Other payments
    • Timber sales, surface damages and easements
    • Payments are first considered a return of basis, amounts in excess of basis are generally capital gains
depletion deduction
Depletion Deduction
  • Tax deduction allowed as compensation for extracting minerals
  • Reduction against royalty income and, in certain cases, lease bonus payments (though for most landowners not likely)
  • For Federal income taxes, there are two possible depletion methods – the greater of (1) Cost, or (2) Percentage Depletion
  • For PA income taxes, cost depletion is the only acceptable method (PA generally does not allow percentage depletion)

Since most landowners will be unable to determine cost depletion, a depletion deduction will be allowed ONLY for Federal income taxes (using percentage depletion) – no depletion deduction for PA income taxes

percentage depletion
Percentage Depletion
  • Deduction amount is equal to 15 percent of the royalties received – resulting in only 85 percent of royalty income being included in the landowner’s income
  • Limitations – Lesser of:
    • 100 percent of taxable income of the property
    • 65 percent of landowners adjusted gross income (AGI)
    • May carry forward amount limited under taxable income limitation
lease income from pass through entities
Lease Income from Pass-Through Entities

Many landowners will receive lease income from “pass-through” entities – partnerships, limited liability companies (LLC) and S corporations

For example, family limited partnerships and LLCs are being used by landowners for various purposes (e.g., estate tax planning, asset protection, etc.)

The amount of lease income included on a landowner’s return will be based on his or her ownership interest in the pass-through entity

The landowner’s share of pass-through entity lease income is reported on Schedule K-1 (Federal) and Schedule RK-1 (State)

lease income from pass through entities cont
Lease Income from Pass-Through Entities (cont.)

The amount of income included on the landowner’s Schedule K-1 may be in excess of the cash distributions received from the pass-through entities

Landowner pays tax on his or her allocable share of income from the pass-through entity – not on the amount of cash distributed

Landowners will need to include their share of income from pass-through entities when determining estimated tax payments

Owners of pass-through entities should take steps to insure minimum amounts are distributed, on a timely basis, to cover quarterly estimated tax payments

The landowner should not file its 2010 tax returns until after it receives the Schedule K-1s/RK-1s from the pass-though entities

changes to income tax profile federal
Changes to Income Tax Profile – Federal

Bonus and royalty income windfalls will change the tax profiles of many landowners – resulting in “hidden” tax costs

Cause landowner to move into a higher tax bracket – for 2010

changes to income tax profile federal cont
Changes to Income Tax Profile – Federal (cont.)

Cause a greater portion of Social Security benefits to be taxed

85 percent subject to tax once “income” threshold exceeds $44,000 (married filing joint) or $34,000 (single or head of household)

Cause a phase out/loss of various tax deductions and credits

First-time / existing homebuyer credit ($225,000-MFJ/$125,000-Single)

Payroll tax credit ($150,000-MFJ/$75,000-Single)

College tuition credit ($160,000-MFJ/$80,000-Single)

Make work pay credit ($150,000-MFJ/$75,000-Single)

Itemized deductions and personal exemptions – No phase out of amounts eligible for deduction in 2010, 2011 and 2012

changes to income tax profile federal cont1
Changes to Income Tax Profile –Federal (cont.)

Cause increases in taxes relating to long-term capital gains and qualified dividend income

Long-term capital gain and qualified dividend tax rates are generally based on the ordinary income tax bracket of the landowner

For landowners in the10 and 15 percent tax brackets, the tax rate applicable to capital gain and dividend income is 0 percent from 2010 to 2012

For landowners in tax brackets of 25 percent and above, the tax rate applicable to capital gain and dividend income is 15 percent from 2010 to 2012

Since lease bonus and royalty income is ordinary income, it is very likely that amounts earned in 2010 to 2012 will likely push landowners into the higher capital gain and qualified dividend tax rates

changes to income tax profile federal cont2
Changes to Income Tax Profile –Federal (cont.)

Lease income may cause landowners to pay Alternative Minimum Tax (AMT)

AMT was designed to make sure wealthy taxpayers with significant deductions do not avoid paying tax

A problem with the AMT exists – it is not indexed to inflation and its related exemption amounts are fixed – causing many middle income taxpayers subject to AMT

To address this issue, since 2001, Congress has annually increased the exemption amount – referred to as “the AMT patch”

AMT patch now in place for years 2010 and 2011

changes to income tax profile pa state
Changes to Income Tax Profile –PA State

Loss of property tax rebate – income is above $35,000

Loss of PACE and PACENET prescription assistance

PACE - $17,700 MFJ / $14,500 Single

PACENET - $31,500 / $23,500 Single

Loss of Tax Forgiveness

slide15

Tax Planning Steps to Reduce

The Impact of Lease Income

tax planning overview
Tax Planning Overview

For most landowners, there are minimal opportunities to directly reduce the taxable amount of income from gas leases

Percentage depletion deduction against royalties

To minimize the tax impact of lease income on taxes, we look at the landowner’s overall tax profile and identify planning opportunities to reduce taxable income, including

Deferring income to the extent possible, and

Accelerating / maximizing deductions

tax planning moves by december 31
Tax Planning Moves by December 31

Defer receipt of year-end bonuses

Request employer to delay payment of any bonus until following year

Avoid including in current year income

Take capital losses

Applies to landowners with unrecognized capital losses

Taking losses will reduce adjusted gross income

Offset capital gains – to the extent there are capital gains

After taking into account gains, landowner may offset $3,000 of long-term capital losses against ordinary income

tax planning actions by december 31
Tax Planning Actions by December 31

For landowners that itemize, make fourth quarter estimated state and local tax payments by December 31

Use credit card to prepay business expenses

Pay contested taxes to deduct them this year while continuing to contest them next year

contribute to hsa by december 31
Contribute to HSA by December 31

To make contributions to a Health Savings Account (HSA)

The landowner must be covered by a qualifying high deductible health plan and not covered under another plan

For calendar year 2010 and 2011, the maximum contribution is $3,050 for self-only coverage and $6,150 for family coverage

Distributions from an HSA to pay for qualified medical expenses are not taxable

Distributions used for nonmedical purposes are taxable and, if made before age 65, subject to a 10 percent penalty tax

make charitable contributions by december 31
Make Charitable Contributions by December 31

Charitable contributions are included as an itemized deduction on Schedule A

The maximum deductible amount is based on the landowner’s AGI, the receiving organization, and type of property contributed

50 percent of AGI if made to public charities and private foundations

30 percent of AGI if made to non-operating private foundations

30 percent of AGI if appreciated capital gain property (for example, stocks) contributed to public charities and private foundations

20 percent of AGI if contributing appreciated capital gain property to non-operating private foundations

Excess charitable contributions may be carried forward 5 years

make charitable contribution from ira
Make Charitable Contribution from IRA

Landowners who have reached aged 70 ½ should consider making charitable contribution from an Individual Retirement Account (IRA)

An exclusion from gross income (not to exceed $100,000) is available for otherwise taxable IRA distributions made to qualified charities

Charitable contribution from an IRA is not subject to the deduction percentage limitations since they will neither be included in gross income or be claimed as a deduction on the landowner's return

Since such a distribution is not includible in gross income, it will not increase AGI for purposes of the phase out of certain deductions

To constitute a qualified charitable distribution, the distribution must be made after the IRA owner attains age 70 1/2 directly by the IRA trustee to a qualified charitable organization

Newest tax law allows 2010 IRA charitable contribution, when made by January 31, 2011

maximize deductions of unreimbursed employee expenses
Maximize Deductions of Unreimbursed Employee Expenses

Federal – Included as an itemized deduction (Schedule A) / deduction limited to amounts greater than 2 percent of AGI

PA State – Amounts are included on Schedule UE and deducted against taxable wages (no deduction limits)

May also deduct on local income tax return, if applicable

Examples include licenses, tools, supplies, work clothes/uniforms, travel (including auto mileage - $0.50/mi for 2010; $0.51/mi for 2011)

Must be required and “ordinary and necessary”

contribute to section 529 college savings plans by december 31
Contribute to Section 529 College Savings Plans by December 31

For PA income tax purposes, landowners may deduct contributions to 529 plans

No deduction for Federal income tax

Amount of deduction is limited to $13,000 per beneficiary, per taxpayer, per year, up to the amount of taxable income

For married filing joint filers, the 529 deduction amount is determined for each spouse based on each one’s taxable income

Contributions eligible for the PA 529 deduction are those made to any qualified 529 plan – does not need to be a PA 529 plan

convert taxable interest to tax exempt interest
Convert Taxable Interest to Tax-Exempt Interest

For example, shifting funds in a taxable money market account to a tax-exempt fund

Especially practical when little or no gain realized on the disposition of a taxable investment

Tax-exempt interest will not be included in taxable income (except in determining the taxability of Social Security benefits)

The after-tax amount received from tax-exempt interest will be at least as much as the after-tax amount received from taxable interest.

Especially true if the tax-exempt interest is exempt from state or local income taxes as well as from Federal income tax

contribute to employer retirement plans by december 31
Contribute to Employer Retirement Plans by December 31

401(k) and 403(b) plans – 2010 and 2011contribution amounts are

Up to $16,500 by employees

If age 50 or older, employee may contribute up to an additional $5,500

Savings Incentive Match Plans for Employee (SIMPLE)

Employees may contribute up to $11,500 in 2010 and 2011

Employers must make contributions equal to the amounts contributed by employees, up to 3 percent of the employee’s compensation

Deadlines to establish plans

401(k) plans – by December 31

SIMPLE plans – by October 1

contribute to a simplified employee pension sep plan
Contribute to a Simplified Employee Pension (SEP) Plan

Eligible for self-employed individuals, partnerships and corporations

Self-employed contributions

Limited to 20% of net self-employment income (after self-employment tax deduction) up to a maximum contribution of $49,000

Employee contributions by employer

Limited to 25% of wages up to a maximum contribution of $49,000.

If contributions are made for self-employed, then contributions must be made to eligible employees

Deadline to start plan is tax return due date (either March 15 or April 15), plus extensions

contribute to an individual retirement account ira
Contribute to an Individual Retirement Account (IRA)

For landowners who do not participate in an employer-sponsored plan

May contribute up to the lesser of $5,000 ($6,000 if age 50 or older)

For nonworking spouse, maximum annual contribution limit is $5,000 ($6,000 if age 50 or older)

Allowed to deduct both taxpayer and nonworking spouse contribution amounts to the extent of the taxpayer’s earned income up to $10,000 ($12,000 if 50 or over)

contribute to an ira cont
Contribute to an IRA (cont.)

For landowners participating in an employer sponsored plan, 2010 IRA deductible amounts phase out at certain AGI levels

Joint returns: Phase out begins at $89,000 with complete phase out by $109,000

Single returns: Phase out begins at $56,000 with complete phase out by $66,000

For landowners who do not, but spouse does, participate in an employer sponsored plan, 2010 IRA deductible amounts phase out beginning at $167,000 with complete phase out by $177,000

Deadline to make 2010 IRA contributions is tax return due date (April 18, 2011)

maximize business deductions
Maximize Business Deductions

Landowners who operate their own businesses should consider maximizing various expenses to reduce business income

Expense up to $500,000 of qualifying depreciable personal property purchased – new or used – in 2010 and 2011(Section 179 expensing)

Claim 50% bonus depreciation allowance on qualifying depreciable personal property purchased – NEW (not used) – in 2010, 100% bonus depreciation for property acquired from 9/8/2010-12/31/2011

Claim $8,000 additional depreciation on passenger autos and light trucks acquired in 2010 and 2011

For new businesses, eligible to expense up to $10,000 of qualifying start-up costs

pa treatment of section 179 bonus depreciation start up expenses
PA Treatment of Section 179, Bonus Depreciation, Start Up Expenses

PA follows the Federal tax rules for Section 179 and Start Up expenses only with respect to the determination of Corporate net income tax

This means that PA C corporations will apply the same Section 179 and start up expense rules when calculating PA corporate net income tax

For S corporations, partnerships and sole proprietors

PA Section 179 deduction is limited to $25,000

PA requires start up costs to be amortized over 15 years

PA does not allow bonus depreciation

self employment tax and health insurance
Self-employment Tax and Health Insurance

Health insurance costs for self-employed are now deductible in computing self-employment tax

Prior to 2010, a self-employed individual’s health insurance costs, although deductible for income tax purposes, were not deductible in determining net earnings from self-employment

Net earnings from self-employment are generally an individual's trade or business income, less the deductions permitted by the Code that are attributable to that trade or business, plus the individual's distributive share of partnership income or loss

Beginning in 2010, a self-employed individual can deduct as a trade or business expense the amount paid during the tax year for health insurance for the taxpayer; the taxpayer's spouse; the taxpayer's dependents; and any child of the taxpayer who hasn't attained age 27 as of the end of the tax year

estimated tax payments
Estimated Tax Payments

Don’t forget the quarterly estimated tax payment rules

For federal income taxes:

If you expect to owe $1,000 or more after subtracting federal withholding taxes from the total tax you expect to owe

Your total withholding tax (plus any estimated payments) is less than 90 percent of the total tax you owe for 2010

Your total withholding tax is less than 100% of the total tax you owed for the prior year (or if your adjusted gross income is over $150,000 for 2010 your total withholding tax is less than 110% of the total tax you owed for 2009)

For Pennsylvania income taxes:

Income is over $8,000, and

Income is not subject to employer withholding

estimated tax payments cont
Estimated Tax Payments (cont.)
  • To fund the payment of estimated taxes, recommend setting aside a percentage of each lease or royalty payment in bank accounts or money market funds
    • For example, if you are in the 35 percent Federal tax bracket, then set aside 38.07 percent (including PA state tax of 3.07 percent) of such payments
    • This will insure adequate funds are available to pay such taxes – thereby avoiding any penalties or interest and possible investment losses (should you need to sell certain investments to fund tax payments)
and finally
And Finally…

December 17, 2010 “Tax Relief Act”

  • “Bush tax cuts” due to expire 12/31/2010 were extended through 2012, including ordinary and capital gain income tax rates, and other provisions, including education-related tax benefits and elimination of phaseout of personal exemptions and limitations on itemized deductions
  • Reduces the employee portion of Social Security taxes paid from 6.2 percent to 4.2 percent for 2011 only
  • AMT “patched” for 2010 and 2011
  • Maximum estate tax set at 35 percent with estate tax exemption of $5 million for 2010 to 2012
  • Gift tax exemption $1 million in 2010; $5 million for 2011 and 2012
  • Portability to surviving spouse of unused exemption in 2011 and 2012
  • 2010 Estates - may elect no estate tax with modified carryover basis
online resources
Online Resources

Visit www.IneedaCPA.org to find more

financial resources including:

  • Marcellus Shale Financial Tip sheets
  • PICPA’s free Ask a CPA service
  • CPA Locator service
  • CommonWealth Tips articles
questions
Questions

Nancy G. Montanye, CPA, CFP, CSEP

353 Pine Street, Suite 1

Williamsport, PA 17701

570-322-1235

nm@nmcpa.net