Marcellus ShaleTax 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

• 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

• 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

• 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

• 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.)

• 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 Overall Tax Profile

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

Tax Bracket – Beginning of Joint Single

Head of Household

Married Filing Separate

10% Up to $16,750 Up to $8,375 Up to $11,950 Up to $8,375

15% $16,750 $8,375 $11,950 $8,375

25% $68,000 $34,000 $45,550 $34,000

28% $137,300 $82,400 $117,650 $68,650

33% $209,250 $171,850 $190,550 $104,625

35% $373,650 $373,650 $373,650 $186,825

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 (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 landownero 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 2012o 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 (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

• 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

Tax Planning Steps to Reduce

The Impact of Lease Income

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

• 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

• 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

• 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

• 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

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

• 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

• 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

• 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

• 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

• 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)

• 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.)

• 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

• 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 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

• 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

• 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.)

• 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…

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

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

Nancy G. Montanye, CPA, CFP, CSEP353 Pine Street, Suite 1Williamsport, PA 17701570-322-1235nm@nmcpa.net