The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
Investing in oil and gas wells and gifting to Charitable Lead Annuity Trusts (CLATs) are two popular strategies for offsetting ordinary income tax. How do you know which one is right for you? This article explains what these strategies are and when they make sense.
Oil and gas drilling investments are exactly what they sound like: investments in oil and gas drilling partnerships. These projects offer substantial tax benefits that can offset ordinary income tax while generating significant income for investors. Best of all, they don’t require investors to do anything other than invest to be considered active.
A taxpayer is able to claim depreciation on oil and gas well investments. This means that a taxpayer who invests in oil and gas wells will be able to deduct the cost of the investment — and typically, the vast majority can be deducted in the first year. Intangible drilling costs (IDCs), which include labor, fuel, and chemicals, are 100% deductible in the first year and can comprise as much as 94% of an oil and gas well investment. Tangible drilling costs, which include project expenses not considered IDCs, are deductible over the course of several years, rather than all upfront.
For example, if you are a top marginal taxpayer in New York City, you could invest $100,000 into oil and gas drilling projects and offset $94,000 of your ordinary income in the first year, saving $50,000 on taxes that year ($94,000 * 53% marginal tax rate)! Much of the remaining $6,000 would be deductible in subsequent years.
In general, U.S. law requires taxpayers to be “active” in an investment in order to use tax credits or depreciation from that investment to offset active income like a salary or income from a business. For example, depreciation from a “passive” real estate investment — one where you buy a property and rent it out without being actively involved — can only be used to reduce your passive rental income. To offset active income, you need losses from a business in which you are actively involved. Typically that means 100+ hours (in some cases 750+ hours) of activity in the business. But oil and gas investments are not subject to this requirement due to a 1913 law, so you can qualify as active without doing any work.
John, a married New Yorker earning $1,200,000 per year, mostly from his W-2 job, historically has invested only in stock indexes. Tired of his $550,000 annual tax bill, John invests $300,000 in an oil drilling partnership. He deducts 94% of this amount as intangible drilling costs in the first year, reducing his taxable income by $282,000 that year (and another $18,000 over the next five years as a result of depreciation for tangible drilling costs). If his marginal tax rate is 51%, that will save him close to $153,000, effectively reducing his at-risk principal to just $147,000 ($300,000 – $153,000), even as John generates returns on his full $300,000 investment. You can estimate your potential returns here!
A Charitable Lead Annuity Trust (CLAT) is an irrevocable trust designed to provide annual distributions to a charity for a specified period, after which the remaining assets are distributed to non-charitable beneficiaries, typically family members but sometimes the donors themselves. In most cases, the CLAT is structured so that the taxpayer receives a charitable deduction equal to the value he or she contributes to the trust. In this way, gifting to a CLAT is similar to gifting to a conventional charitable vehicle, like a Donor Advised Fund. The difference is that, with a CLAT, the donor or his or her family can keep the charitable vehicle’s investment returns to the extent they exceed the IRS hurdle rate, which is typically 2-5% per year. If you contribute $1 million to a CLAT and the CLAT generates 10% annual returns, you may be able to not only claim a $1 million deduction upfront but also walk away with a six-figure or even seven-figure remainder interest at the end of the term.
CLATs tend to work best if some combination of these factors are true:
Benjamin, a married California resident, earns $1,200,000 per year. Because his annual tax bill is $550,000, Benjamin is focused on tax mitigation. Benjamin is charitable; going forward, he hopes to give $120,000 a year to his religious institution. He could give away $120,000 outright each year. Or, he could set up a CLAT in a year when he has a particularly high income, and then use the resulting charitable deduction to offset a substantial chunk of his income in that year while also setting up a $120,000 annual income stream for charity. In this way, he’ll be able to accelerate his charitable deductions while also potentially keeping a portion of the excess returns on the amount that puts into the CLAT. Compared to some other tax-mitigation strategies, CLATs tend to have a lower ROI because the donor is giving away a chunk of his or her assets. But they have a higher ROI than simply gifting to a Donor Advised Fund or most other charitable vehicles, so they make a lot of sense for people who are charitably inclined. You can estimate your potential returns here!
Investing in oil and gas wells and gifting to CLATs are both attractive strategies. But there are also important differences between these two strategies. From the donor’s perspective, oil and gas wells are probably the higher-return choice. Not only do they yield upfront tax benefits, but they also generate income for years to come. With a CLAT, there’s a chance that the donor or the donor’s family will be able to receive the remainder interest, but that may take decades to materialize and, even if it does, it may not be very large. That said, if the goal is to support a charity, then a CLAT can make sense.
Investing in oil and gas wells and gifting to CLATs are both viable tax strategies, but they serve different objectives. Hopefully this article has given you a better idea of what each strategy entails, and whether one or the other might be a better fit.
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