Investment into Pennsylvania’s oil and gas industry is increasing at a profound rate. In the current decade (since January 1, 2010), the Pennsylvania Department of Environmental Protection has issued a total of 15,487 permits in connection with unconventional gas wells.(1) In counties surrounding the Pittsburgh area, such permits have been issued as follows:(2)
Pennsylvania law defines “unconventional gas well” as “a bore hole drilled or being drilled for the purpose of or to be used for the production of natural gas from an unconventional formation.”(3) An “unconventional formation” is defined as “a geological shale formation existing below the base of the Elk Sandstone or its geologic equivalent stratigraphic interval where natural gas generally cannot be produced at economic flow rates or in economic volumes except by vertical or horizontal well bores stimulated by hydraulic fracture treatments or by using multilateral well bores or other techniques to expose more of the formation to the well bore.”(4) The ability to extract gas from the Marcellus Shale formation through hydraulic fracture treatments, commonly known as “fracking,” has significantly contributed to the increase in unconventional well permitting.
Oil and gas producers in Western Pennsylvania are planning for the long-term when investing in Marcellus Shale.(5) Therefore, purchasing oil and gas rights, as opposed to leasing, may be more advantageous not only to the producers/investors, but also to the landowner who can obtain a higher upfront per acre payment from a sale compared with a lease. Even if a landowner’s oil and gas rights are currently subject to an existing lease, oil and gas producers or other investors may still be willing to consider purchasing these rights. Oil and gas rights can be severed and conveyed separately from the surface rights of property through a well-crafted oil and gas deed, often referred to as a hydrocarbon deed.
In any sale of real estate, including oil and gas rights, two issues that must be addressed are liability relating to title, and payment of realty transfer taxes. The formation of a limited liability company (“LLC”) to hold oil and gas rights is one potential strategy to address liability relating to title. The conveyance of oil and gas rights to this LLC prior to negotiating the sale of such rights is a potential approach to minimize transfer tax liability.
In Pennsylvania, the sale of real estate is typically accomplished by either a general warranty deed, or a special warranty deed.(6) “A [seller] by general warranty is obliged to deliver a deed that is free of liens for taxes and he covenants to defend the grantee’s title against all mankind, the whole world.”(7) In a special warranty deed “the purchaser  is not entitled to anything more than a covenant against the acts of the grantor and his heirs.”(8)
Determining whether or not a landowner in fact owns legal title to the oil and gas rights under his property is a time-consuming and expensive task requiring a search of records literally back to when William Penn owned the land that is now Pennsylvania. To landowners who would rather not expend resources to conduct such a search, but would like to offer a prospective purchaser a general or special warranty deed, forming an LLC to hold title to oil and gas rights may be an attractive option. This is because, under the Limited Liability Company Law of 1994, 15 Pa.C.S. §§ 8901 et seq., “the members of a limited liability company shall not be liable, solely by reason of being a member, under an order of a court or in any other manner for a debt, obligation or liability of the company of any kind or for the acts of any member, manager, agent or employee of the company.”(9) Thus, if oil and gas rights are held by the LLC in which the landowner is the owning member, liability for any title issue either discovered, or arising subsequent to the conveyance may affect solely the LLC, thereby insulating the member/landowner from personal liability while also protecting his surface rights. To accomplish this, the landowner conveys his oil and gas rights to the LLC, and the LLC then conveys the rights to the ultimate purchaser.
Pursuant to the Tax Reform Code of 1971, in a conveyance of oil, gas, and mineral rights, realty transfer taxes must be paid to the State “at the rate of one per cent of the value of the real estate”(10) and to local taxing authorities at their established rates.(11) This is because the definition of “real estate” includes “… minerals, oil, gas …”(12) Transfer tax is imposed upon the “value” of the real estate which, in a typical transaction, means “the amount of the actual consideration therefor, paid or to be paid.”(13)
Suppose an oil and gas producer has already approached a landowner to purchase his oil and gas rights at a price of $10,000 per acre and he owns 100 acres of property. The amount of the actual consideration to be paid is $1,000,000. Transfer tax at the rate of two percent (2 %) would result in taxes of $20,000 (=$10,000/acre x 100 acres x 2 %). If a landowner conveys to an LLC, which then conveys to the ultimate purchaser, taxes must be paid on both transfers. Although there may be no actual consideration paid in the initial transfer from the landowner to the LLC, this transfer is still subject to tax based upon “the actual monetary worth of such interest.”(14) Because the landowner has already been approached by a purchaser who has valued the rights at $10,000 per acre, it follows that this valuation should be used as the actual monetary worth of the interests. The tax due on both transfers totals $40,000.
A different situation arises if a landowner conveys to an LLC before being approached by a purchaser. There is a wide range in what oil and gas producers and investors are willing to pay for oil and gas rights. This grants some latitude for the landowner in determining the actual monetary worth in a transfer to the LLC. For example, the landowner may be able to procure an appraisal stating that the value of his oil and gas rights is only $2,000 per acre (15).
In the above hypothetical, if the landowner conveys to the LLC, then transfer taxes paid based upon the appraisal valuation would be $4,000 (=$2,000/acre x 100 acres x 2%). While the oil and gas rights are held by the LLC oil and gas producers may then approach and offer to purchase at a greater valuation such as $10,000 per acre. As discussed above, the transfer taxes paid on the second conveyance to the oil and gas producer would be $20,000. The taxes paid on both transfers now totals only $24,000. Here, where the landowner conveys oil and gas interests to an LLC prior to being approached by a producer/investor, and the LLC then conveys the interests to a producer/investor, the savings in transfer taxes paid is $16,000 (=$40,000 – $24,000).
The formation of an LLC is routinely utilized to protect individuals participating in business ventures. This technique can have the same application for landowners participating in oil and gas ventures. At Sebring & Associates, our attorneys can advise on the following matters:
- Review of existing oil and gas lease
- Review and negotiation of proposed oil and gas lease
- Formation of legal entity to hold oil and gas rights in sale or lease
- Review and negotiation of agreement of sale for oil and gas rights
- Drafting of hydrocarbon deed and conveyance of oil and gas rights
If you have a concern regarding your oil and gas rights, please contact one of our attorneys for a consultation.
(1) See http://www.depreportingservices.state.pa.us/ReportServer/Pages/ReportViewer.aspx?/Oil_Gas/Permits_Issued_Count_by_Well_Type_YTD
(3) 58 Pa.C.S. § 2301.
(5) Litvak, Anya, “Marcellus Players Looking Long-Term,” Post-Gazette 11/11/2014, http://powersource.post-gazette.com/powersource/companies-powersource/2014/11/11/Marcellus-players-looking-long-term/stories/201411110022.
(6) Another method is by quit-claim deed. “[A] quit-claim deed is ‘intended to pass any title, interest, or claim which the grantor may have in the premises, but not professing that such title is valid, nor containing any warranty or covenants for title.’” Baker v. Cambridge Chase, Inc., 725 A.2d 757, 770 (Pa.Super 1999). However, many purchasers are unwilling to accept a quit-claim deed because it offers no warranty of title from the seller.
(7) Zurich General Acci. & Liability Ins. v. Klein, 121 A.2d 893, 895 (Pa.Super. 1956).
(8) Lloyd v. Farrell, 48 Pa. 73, 78 (Pa. 1864).
(9) 15 Pa.C.S. § 8922(a). There are exceptions to this rule and all cases should be analyzed by a licensed attorney.
(10) 72 P.S. § 8102-C.
(11) Id. at § 8101-D. Most, but not all, municipalities and school districts tax at a rate of one-half percent (1/2 %) each which, combined with the State transfer tax, results in an aggregate realty transfer tax rate of two percent (2 %).
(12) Id. at § 8101-C.
(15) The value of real estate shall be determined by appraisal when “the real estate is not the subject of a bona fide sale, cannot be valued under § 91.133 (relating to leases) and is not separately assessed for local real estate tax purposes.” 61 Pa.Code § 91.136(2). See also Pa. Dept. of Rev. Informational Notice Realty Transfer Tax and Personal Income Tax 2012-04, Division and Transfer of Interests Related to Oil and Natural Gas, Issued October 10, 2012, Section III(A)(3)(“In addition to an appraisal, the department may in its discretion accept other credible evidence of the value of mineral rights such as comparable sales. Also see Inheritance Tax Bulletin 2012-01 for additional acceptable valuation methods for natural gas rights when there is no sale price, appraisal or other credible evidence”).
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