Tax Law and Business Organization Strategy

Wind Energy Part 2 -- Assignment of the "Tree" or the Income the "Tree" Produces

If I assign “wind rights,” either for a term of years or in perpetuity, have I actually assigned “property” from which income is produced, or have I simply assigned income from that property?

Here, for federal income tax purposes, the concept of “economic interest” and its related concept of “assignment of income” may be instructive or even applicable. The concept of “economic interest” arose to determine to whom the income from the production of minerals is taxable and whether there is “property” that can be depleted (or amortized or depreciated). Even if the term does not apply to wind energy, the concept does. The income that a property produces, for tax purposes, belongs to the person who owns the property for tax purposes and will be taxed to that person. If a person desires to change to whom the income is taxed, they must assign not only the income but the tax ownership of the property that produces the income. For example, if I own real estate that I lease to another, I cannot simply assign the rent income, and not the property that produces the income, if I am to make the rents taxable to the person to whom I made the assignment – or can I?

So, the discussion in the first part of this series regarding the nature of wind rights under state and federal law may be important in determining whether wind rights may be severed for federal income tax purposes, which may be required before the taxation of the income from those wind rights may be transferred to someone else. That is, if state law will not permit the severance and conveyance or retention of wind rights without any surface ownership, will federal tax law follow state law and only tax the person who owns the surface for the rents produced in a wind lease?

Federal tax law, typically, looks to the rights created under local law to determine the federal tax consequences of those rights. But it does not always follow the labels that local law imposes. Thus, it is possible to have a partnership for federal income tax purposes where one does not exist for state law purposes. Likewise, in states where subsurface minerals cannot actually be owned until they are produced, the concept of “economic interest” treats persons as owners even where they may not hold “title” to something under local law. Therefore, it is likely that the severability of wind rights for state law purposes will not govern ownership of wind rights for federal income tax purposes. But it will still be necessary to determine who, for federal tax purposes, owns the various properties or “economic interests,” involved in wind production to determine to whom the income produced by energy will be taxed, and to determine its character.

While the tax law itself determines to whom income is taxable, the tax law first looks to the rights and duties created by local law, and then applies tax law concepts to those rights and duties. Therefore, if, under Texas law, the ownership rights and duties pertinent to the production of energy from wind cannot be assigned separate from ownership of the surface, it may still be possible under Texas law to create sufficient rights in a non-surface owner that they are considered to be an owner of property that produces income for federal tax purposes.

Many of the practitioners in this area recognize this and advise that if one is going to attempt to make a conveyance of “wind rights,” that conveyance should describe those rights in detail. But I would also caution practitioners: I have seen some “severances” of “wind rights” and “wind royalties” that only describe the specific types of income that are being assigned. If you do not convey some bundle of rights that is considered to be property for federal income tax purposes other than just income, you may not have created something that qualifies as property, or an “economic interest,” for tax purposes. If that is the case, you may not have shifted the federal income tax burden.

If you’ve looked at a wind lease, they are, in essence or economically, just ground leases with “bonus” rentals based on the income of the lessee from their use of those rights to produce income. That is, the lessee pays to acquire the rights to use, as a lessee and holder of easements (or perhaps usufructs), certain parts of the surface (or the immediate space above the surface and the immediate subsurface) to construct turbines and related gathering and transmission facilities. Regardless of what the payments for use of the land are called, for tax purposes, they will be characterized according to how payments for the use of land are taxed. In the case of arrangements for the use of land for periods of less than 30 years, they would probably be most analogous to, and be treated as, rents for real property. (More on treatment of longer term leases later.) And, they would probably be treated as such no matter what they are called in the document. That is, even if the documents call them rents, royalties, bonus, etc., they would probably be treated as rents arising from the “sale” of the rights to use the “surface.” And they would be taxed to the person who owns the “surface” that is being leased – or would they?

Wind Contracts As Property for Federal Tax Purposes

Certainly, in the case where the owner of the property leased is also the lessor under the lease, the rents produced by the lease would be taxed to the owner/lessor as something in the nature of rents. But what if that owner/lessor assigns the lease (or a portion of it) to someone else? What if the lease is for a term of 50 years, and it is assigned to someone else? What if the assignment of the lease occurs before the lease is even entered into?

The answers to these questions may depend on whether you can sever the rights to wind energy from the surface to create an “economic interest,” or the like, in wind energy or a royalty interest in the income produced by the wind energy. They may also depend on whether leases with a term of more than 30 years carry some sort of “ownership” or “economic interest” with them for tax purposes.

There are also issues revolving around long term leases. The like-kind exchange rules treat leases of real estate with a potential term of 30 years or more as being of a like-kind to ownership estates in real property. There are indications in the sale and lease-back arena that the IRS would like to treat long-term leases as equivalent to ownership of the real estate involved. Most wind leases have terms exceeding 30 years. In fact, it is not unusual for them to have 50 year terms without regard to options to extend. So this raises the question of whether, for federal income tax purposes, a 50 year lease is actually a sale of property, rather than a lease, and whether the lease itself is property separate and apart from ownership of the surface or the thing being leased. If a long term lease is actually a sale of property, then, instead of a lease producing rental income, I may have entered into an installment sale producing gains and imputed interest income or original issue discount. Such a result would come as a surprise to almost everyone involved; and, with the lack of authority in this new and unique situation, it could be risky to take either position – that the lease is actually a sale or that the lease is actually a lease.

But there does seem to be authority for treating the lease, once entered into as property – at least as property that may be exchanged in a like-kind exchange. And if it may be exchanged in a like-kind exchange, why can’t it be sold in a taxable transaction? Or gifted? Why couldn’t the rights under such a lease be transferred even before such a lease is entered into and exists? And, if sold, wouldn’t any of those properties, if properties for tax purposes, qualify for capital gain treatment?

The answer to these questions become even more uncertain when you consider that wind arrangements usually include the grant of easements in addition to the renting of the surface. Easements are generally considered to be real property estates, which may be severed from the fee ownership. How do these additional rights granted affect the characterization of the transaction as a lease or a sale? Or as the creation of another “property” that can be bought and sold?

These questions will eventually have answers. And the answers for state law purposes may be different from those for federal income tax purposes. I, personally, find it likely that it will be, and in fact already is, possible to convey a bundle of rights for a sufficient period of time that those rights will be considered as property, or an “economic interest,” for federal income tax purposes. But exactly what rights must be conveyed, for what period of time, and in what fashion are, for the time being, undecided.

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Comments (1) Read through and enter the discussion with the form at the end
Allen Price - January 17, 2009 11:08 AM

I appreciate very much your thoughts on this. I will be speaking at the UT Wind Energy Conference in Austin on Jan 20, 2009 in the panel on Issues for Land Owners and Ranchers and plan to mention your blog.

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