Proper prior planning is essential when it comes to dealing with financial windfalls such as bonus money and royalties paid out for oil drilling rights.
Your failure to do so could cost you a lot of money and even the land that brought you all that income if you don’t take the time to prepare, says Broderick N. Haer, a financial consultant at AXA Advisors LLC.
“This is like winning the lottery,” Haer says. “A common mistake with bonus and royalty money is that people don’t know how it’s treated in terms of taxes. In most situations, the bonus payment, as well as the royalty income stream, is considered taxable income. So when you’re getting tremendous amounts of dollars in terms of ordinary income, it obviously has a dramatic effect on your effective tax rate.”
Haer says the oil and gas drilling boom in Ohio has been a learning process for financial professionals as much as the people getting the money.
“The key is to talk about it in more simplistic terms and handle it in a methodical, step-by-step process,” Haer says.
Smart Business spoke with Haer about how to manage a sudden surge of income in a way that helps to protect you, your family and your property.
What’s a common mistake made with a sudden infusion of income?
Often, the first thing you want to do with a windfall of money is start paying off debt on the farm or purchase assets such as a new tractor or tiller or a new truck. You have this bonus money and you’ve spent the majority of it without leaving enough for the expected taxes that you’ll need to pay on it. Step back and plan how you’re going to distribute the income and properly save for taxes.
How comprehensive is the planning process?
It can help you understand whether the income may be extensive enough to support future generations, which would involve legacy and estate planning strategies such as trusts, limited partnerships or even family limited partnerships.
An advisor can sit down and run a financial plan and look at the bonus and/or royalty money you expect to receive. When your land is drilled and the wells are productive, you can start seeing extreme income that becomes very lucrative.
In this case, you’re going to need a more professional approach with a team of advisors. This includes an estate and contractual attorney, a good CPA and a financial professional that can head up that team.
How important is estate planning?
The value of your property before royalties may be below the estate planning limits for estate taxes. But after drilling, within a very short period of time, the value of that property and the value of that lease could dramatically exceed the estate planning tax exemption.
If that happens and you haven’t planned for it, the result could be devastating.
Let’s say something happens to you and now estate taxes are owed and there’s no liquidity coming in because that tax bill is going to be evaluated based on all the future cash flows of that well.
The IRS is going to have someone come in, a geologist, and find out what is expected in terms of future income. Then they are going to go to a present value calculation and they’re going to put it in today’s dollars and that property can be worth $15 million or 20 million.
Maybe you have just gotten a couple royalties. Now there is an estate tax bill that is due by Oct. 15 of the following year and it’s a $3.5 million to $4 million bill. What’s going to happen to the farm?
You’ll probably have to sell it to the highest bidder. If you haven’t saved enough for estate tax or put a product in place such as a life insurance policy that is liquid upon death to pay those estate taxes, the IRS is going to want its money. The most valuable asset in that situation is the lease, so the lease might be sold and now the family loses the lease or the farm might be sold. That’s a scary notion. ●
Broderick Haer offers securities through AXA Advisors, LLC (NY,NY 212-314-4600), member FINRA/SIPC, offers investment advisory services through AXAAdvisors, LLC, an investment advisor registered with the SEC, and offers insurance and annuity products through AXA Network, LLC.
Broderick Haer, AXA Advisors and AXA Network do not offer tax or legal advice. Please consult with your professional tax and legal advisors regarding your particular circumstances.
