Is There a Permanently Severable "Wind Estate" In Texas?

Lisa Chavarria’s article on The Severance of Wind Rights in Texas was recently published on the Dallas Bar Association’s website. The article recognizes that there are questions about whether there is a severable real property estate consisting of wind rights. Legislative guidance may be necessary, particularly if the Texas courts don’t address this issue soon.

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Texas Schools Using Wind Tax Abatements to Avoid "Robin Hood" Tax

Danny Robbins reports that many school districts have granted tax abatements for wind projects and the results are more income to the school districts. See, Texas Schools Get Millions from Wind Farm Deals. But those payments are in lieu of taxes instead of in the form of taxes. Therefore, the school districts do not include those receipts in the formula for determining the amount of tax revenues that they must return to the State of Texas to fund the statewide equalizing payments for education expenses. This has created a controversy explained in more detail in Robbins' article.

Argument for Continued Expansion of Wind Power Projects

Paul Sadler, Executive Director of the Wind Coalition, believes that effective power storage will someday be an economical reality. Therefore, we should continue developing wind energy capacity. See, The answer is in the wind.

Wind Credits Giving Way to Direct Financial Aid

Wind developers have in the past relied on wind energy income tax credits to attract capital investment in their projects. But those credits require taxable income to remain usable. In the current economic times, investors with taxable income are harder to come by.

Some wind developers are now looking at whether the direct monetary aid contained in the American Reinvestment and Recovery Act might be accessible as reported in Wobbly wind sector sets sights on stimulus.

Wind Energy Part 7 -- Tax Partnerships in Wind Energy Development

Could the use of an arrangement that is taxed as a partnership result in better tax outcome for landowners and/or the wind developers?

Frankly this occurred to me as I was comparing a wind development to a sharing arrangement in the mineral production arena. Sharing arrangements have always struck me as sort of a “frontier” partnership arrangement. And, now, at least in joint operations among “economic interest” holders, they appear to be considered partnerships for tax purposes, to which Subchapter F applies if they do not elect out. I do not think that the typical arrangement between a wind developer and a landowner would be considered a partnership for federal income tax purposes. But might some of the preceding uncertainties be cured by the use of a partnership?

Joint operations of mineral properties are considered partnerships for tax purposes because of the joint operations they undertake – and, perhaps more importantly, because of the joint ownership interests involved. While I, personally, have basically concluded that the owner of the wind rights does have an “economic interest” in those wind rights, I do not think that there is a joint ownership of those rights. Stated another way, the developer makes his income from selling electricity produced by the combination of wind turbines (owned by the developer) and wind (purchased by the developer from the surface owner). The surface owner makes his income from allowing the developer to use his wind. In the case of joint operators in mineral production, they are all considered to own part of the mineral being produced and their joint income comes from the sale of that jointly owned mineral.

Nonetheless, it is possible that they could be considered to be a partnership for tax purposes, particularly where the lease is for a long term. After all, the use of property for 50 years does start to look like an equity contribution to a joint enterprise rather than allowing the use of property as a lessor.

But even if the arrangement is not already considered a partnership for tax purpose, should the landowner and developer consider an arrangement treated as a partnership for tax purposes instead of a landlord/tenant arrangement? I don’t intend to go into the detail necessary to adquately discuss the pros and cons of (or the arrangement necessary for) the creation of a tax partnership. Partnership taxation has many consequences and might require many local law consequences that are unacceptable to the parties. So, I simply raise the question for now.

One should also consider, apart from the possible forced or voluntary partnership of the parties to the entire wind development, whether a partnership produces certainty out of uncertainty when attempts are made to carve-out differing rights to the lessor’s income in a wind energy development. For example, instead of trying to carve out a "royalty" in wind rights, might it be better to form a partnership, create a class of interests with "royalty-like" rights, and convey those interests? Partnership tax law certainly provides more certainty in the face of the questions of what bundles of rights actually create property for tax purposes. Is there a benefit of sounder footing for tax purposes if one were to convey all surface rights, including “ventian” rights, to a partnership that allocates income in whatever fashion is desired (within the strictures of “substantial economic effect”), and then to convey partnership interests in the partnership to reach the desired economic division of those rights, rather than attempting to “carve out” those income rights from the real estate?

Wind Energy Part 6 -- Tax Abatement Issues

As mentioned in Part 5, the Texas Attorney General has issued an opinion treating the wind turbines, etc., as personal property belonging to the wind developer/lessee. The implications of this ruling are fairly wide-reaching. For that reason, if the AG is not persuaded to change his opinion, I think the legislature will probably act to allow abatements on wind turbines, etc.

The AG’s opinion was requested in the context of granting a tax abatement to a wind developer. Apparently, one of the owners of the land to be developed also sat on the body with the power to grant the abatement. The law restricts the makeup of that body to those who are not being granted an abatement. Rather than simply resigning from the body, the land owner forced a requrest for an AG’s opinion to the effect that the wind turbines, etc., were the only property on which the abatement was to be granted. Those properties belonged to someone other than the member of the commission. Therefore, the law was not violated, as the member of the body was not receiving an abatement.

The AG in effect agreed with the outcome regarding the member of the body, but its reasoning prevented the abatement from being granted in the first place. The abatement statute only allows an abatement for real property. The AG found that the wind turbines, etc., since they were owned by someone other than the land owner, were fixtures that should be treated as personally property belonging to the developer and not the surface owner.

Most all wind farms are subject to an ad valorem tax abatement of some sort. This ruling brings all of those abatements into question.

Wind Energy Part 5 -- Ad Valorem Tax Issues

While I’ve noted for federal income tax purposes that the state law characterization of the wind deal is only indirectly affected by the legal “names” given to wind rights, when it comes to state taxation, those “names” have definite tax consequences. What difference does it make for ad valorem tax purposes whether there is actually a wind estate or only “ventian” rights?

If, under Texas law, there is an actual wind estate, like a mineral estate, that can be severed and owned separate from the fee estate, then that estate would undoubtedly constitute real estate subject to separate taxation, when and if it is severed. In addition, when that estate, even if not severed, begins to add separate value to the ownership of the real estate to which it is appurtenant, it will begin to have an effect on the value of the real estate for ad valorem tax purposes.

If, instead of a wind estate, there are “ventian” rights, does that change the result for ad valorem tax purposes? There is some authority in Texas for the proposition that riparian rights may be severed from the surface ownership to which they attach. If that were the case, then presumably, “ventian” rights would be subject to ad valorem taxation in the same fashion as they would if they are an actual wind estate. But there is also some authority that indicates while severable, riparian rights must still attach to a surface estate that also has riparian rights in the same watercourse. Under this interpretation, “ventian” rights would always simply be something to include in valuing the real estate to which the “ventian” rights attach. And, whatever it is that might be conveyed to a person when “wind rights” are conveyed, it is not an estate in real property.

What about the value of the property placed on or affixed to the surface by the wind developer/lessee? Prior to the Texas Attorney General issuing its opinion on tax abatement (discussed in Part 6), the consensus seemed to be that this property was part of the surface to which it was attached (like a building) and would be taxed to the surface owner as an increase in value to the surface estate’s owner. For this reason, wind leases call for the lessee to pay the increase in property taxes imposed on the surface owner by reason of the turbines and other property affixed to the lessor’s property. But this is simply a contract right, and does not change the legal liability of the landowner/lessor to pay the taxes attributable to the value of the turbines, etc.

However, the Attorney General appears to believe that, since the turbines and other property are not owned by the surface owner, that they should be taxed separately to its actual owner. From the standpoint of the surface owner, this is actually a beneficial interpretation. If the wind developer has to pay its own tax on the value of its property, the surface owner does not have to collect the tax from the developer. The government collects its tax directly, and the surface owner doesn’t have to rely solely on a contract provision to collect the developer’s share of the tax and then pass on that payment to the government. While the Attorney General thinks the turbines, etc., are separately taxable personal property, there is, as yet, no case law or statutes supporting or rejectding that interpretation.

Wind Energy Part 4 -- Option Payments as Deferred Income

Many energy deals start with an option to “explore,” or study, the wind energy capabilities of land that may be leased. Would these option payments be taxed just as any other option payments?

When, for example, a cash method taxpayer receives money for an option to purchase property, the taxpayer doesn’t take that income into account until the option is either exercised or expires. At that time, the character of the consideration, money or other property, is determined and either included as purchase price (if the option is exercised) or as income (if the option expires).

There is no reason not to suppose that option payments in a wind deal would be treated in the same fashion. But, again, there is no specific authority for such a conclusion.

Wind Energy Part 3 -- Royalties

I’ve discussed whether the rents from a wind energy deal would be rental income (ordinary income) or gain from the sale of something (presumably capital gain), but what about “royalties”?

Wind leases typically provide for additional payments based, in some fashion, on the income produced by wind energy production. However, unlike oil and gas production, the lessor in a wind transaction doesn’t actually own the production – the electricity. Contrast that with the characterization, for tax purposes, of oil and gas production. In oil and gas production, each owner of an “economic interest” is considered to own his share of production (and will, therefore, have to pay tax on his share of the production). So, a royalty in the oil and gas arena is actually considered to be ownership of production. However, in a wind lease, it seems pretty clear that the income is being produced from the sale of electricity – not from the actual sale of wind. Therefore, it would seem to follow that all of the income from the sale of electricity would be taxed to the developer/lessee. Any “royalty” that was paid would be more in the nature of rent that is simply measured by the income generating activities of the lessee – much like a shopping mall lease.

That conclusion really has no practical effect. That is, the “royalties” would be taxable in the same fashion as any other rent coming due under the arrangement. It is simply semantics. However, when you’re dealing with land-owners who are familiar with royalties in the oil and gas context, it may be a disservice to your client to refer to them as royalties.

But there may be a bundle of rights in a wind energy project that is equivalent, or at least analogous, to the rights of royalty holders of oil and gas production. In the oil and gas context, a royalty is the bundle of rights that gives the holder a non-executory right to oil and gas production. That bundle of rights is carved out of the mineral estate. And, it is considered, for federal income tax purposes, to be an “economic interest,” or property. Mightn’t there be a similar bundle of rights that can be carved out of a larger bundle of rights that, for tax purposes, is considered to be an “economic interest,” or property? If so, how “big” does that bundle of rights have to be for it to gain the status of an “economic interest,” or property, for federal income tax purposes?

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?

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Thoughts and Questions on the Tax Aspects of Wind Energy

Wind energy is quickly becoming big business in the part of Texas west of the Dallas-Fort Worth to San Antonio corridor. I live in Amarillo and my children live in Austin and San Marcos. My in-laws live in Kingsland and the surrounding area. Each time I make the drive, the wind farms from Snyder through Sweetwater and Abilene are larger than the last time I made the drive. My law partner whose children live in San Angelo says the same thing each time he makes that drive. Speaking from personal experience, the wind blows even more in the Texas Panhandle than it does in those areas. There are projections for as many as 7,000 wind turbines in the Panhandle. Each turbine can produce as much as 2 megawatts. (A megawatt meets the electricity needs of about 240 homes.) So, it would seem only a matter of time (and transmission lines) before the wind farms in my neck of the woods exceed the size of those in central West Texas. The wind energy production capacity of Texas is already the largest in the nation, and seems destined to grow even larger and at a rapidly increasing rate. Boone Pickens has plans for a 4,000 megawatt wind farm in the northeast Panhandle, which includes plans for privately constructed transmission lines. (That is roughly the equivalent of two Comanche Peak nuclear power plants and enough juice to power several hundred thousand homes.) Wind energy, a renewable or, more likely, constant resource, has the potential to exceed the economic activity that oil and gas and now water has and is already pumping into the West Texas economy.

As a result, my firm is being called on more and more to advise land-owners and wind energy developers regarding wind energy activities. That means that I, as a tax practitioner, must begin to understand the tax implications of those activities, whether the practitioners involved in the agreements regarding wind energy development realize the importance of tax planning in those relationships as yet.

When I first began considering the tax implications of wind energy development, I assumed that the property rights and tax aspects of those activities would be analogous to other energy related mineral activities – i.e., oil and gas. However, the more I understand the technology and the relationships involved, the more I become convinced that we will experience the development of an entirely new area of law, and related tax law. While oil and gas law and its associated tax law are without a doubt instructive, the analogy is imperfect and may begin to break down as the industry becomes more mature.

There are many considerations that have to be taken into account when advising those involved in wind energy development. The developers, because of the large amounts of capital and financing necessary to develop, build, and operate wind farms (now in the neighborhood of $2 million dollars to simply construct a single wind turbine) are represented by large law firms with their large legal resources. But, landowners who are negotiating with wind energy developers, tend to rely on their personal advisors who may be well versed in real estate law and oil and gas law, but who are just beginning to understand the current implications of the legal attributes of wind development. Most of them are certainly not tax experts. And, even if they were, they might not fully comprehend all of the implications of wind energy, particularly as those implications have not been fully developed as an area of tax practice.

About the only thing we can currently be certain of regarding the tax implications of wind energy, particularly as they apply to land owners, is that the law is uncertain because of the novel concepts involved. What this article (including its related entries) hopes to achieve is to first dispel the idea that mineral energy deals are the same as wind energy deals and then to expose some issues where that difference might produce some tax planning opportunities. As I am dealing principally with large concepts in a new area of activities where there is not a lot of decided law, I am not even going to attempt to cite decided law. So, you are not going to see any citations to decided law.

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