Tri-State Neighbor: South Dakota Farm Newspaper

Dear Michael: My mother is living in northwestern North Dakota and recently her minerals leases - which she always received income from every five to 10 years - are now going to pay royalty income. Dad died a few years ago thinking these leases would never amount to anything so he transferred them to Mom, along with the land, a few years ago at his death. However, if the oil company estimates are correct, Mom, who has never spent even her Social Security check for the past five years, is going to receive over $20,000 to $30,000 a month in oil royalties. Mom's health isn't the best and we were considering putting these mineral rights into a trust for her benefit. If we hold the income in the trust, we should be able to pay for long-term care costs for her, shouldn't we? - Mom Won't Spend.

Dear Mom Won't Spend: The good news is if you are going to use the royalties to pay for long-term care, for $20,000 a month, you could keep her in Hawaii.

The bad news is if you retain income within any type of trust, IRS will hammer you on income taxes. On any income retained by a trust, your tax bracket on anything over only $8,650 per year in income will be taxed at 39.6 percent federal - not including any state taxes, which will increase the total tax to around 45 percent or so. As you can see, the tax brackets to trusts start at a much, much lower amount than taxes to individuals or married filing jointly.

This means your $20,000 per month will generate about $9,000 a month in income taxes and you will net only $11,000.

If you like paying income taxes, then retaining income in a trust is the way to go!

If you're like most normal people and don't really like paying income taxes foolishly, then you'll find a better route to go than retaining income in a trust. As such, almost all trusts pay out income to beneficiaries.

In this case scenario, you want your mom to be both grantor (the person who makes the gift to the trust) and beneficiary. She can then name other income beneficiaries to the trust such as her children. Based on the amount or percentage of income she keeps from the trust versus how much the trust dispenses to the children will determine the value of this transfer. The value of the transfer is important because there is another rule that states if you exceed $12,000 per person, then the excess amount would be deducted from Mom's Unified Credit of $2 million upon her death.

For example, if the income were $240,000, the total value of the minerals would be $240,000 times three years or $720,000. Let's say Mom keeps one-half of the income from the trust - which means she retains $360,000 of value, but now has made a gift of $360,000 to her children. If she has five children, each child is entitled to a gift of $12,000 or a total of $60,000. If you were following the math here, the excess gift would then be $300,000.

IRS then states this “excess gift” would be deducted from Mom's $2 million dollar Unified Credit at her death. As such, her estate must stay below $1,700,000 or it will incur estate taxes. This is why you want to make the transfer prior to receiving royalty checks because now you can base the gift on the value of lease income versus royalty income.

Of course, you'll say “there's no way Mom's estate goes over $1,700,000,” but remember, she's likely going to be accruing her income from the trust, plus she still owns land, savings and other assets where it's pretty easy to hit that mark.

The second part of the equation is this. Mom made a gift and gifts are subject to a five-year lookback rule for long-term care costs. Now, theoretically, if she retains the right amount of income, long-term care costs should be easily met - unless her costs of care really skyrocket. But all of the income beneficiaries have to be aware there is a possibility of recapture on their income received by the trust and should treat their income distributions as only a short-term loan - until the five years passes on each distribution.

This is why it's so important to set up these mineral trusts correctly with all aspects of planning in mind. You have to have one eye on IRS, another eye on Medicaid and a plan that dissects all of these possibilities with the best possibility for success based on a formula for gifting, income and retention of assets.

Mineral trusts are not difficult, but they do require a lot of discussion as to how the trust language reads on handling of income, time frames for retention of income, and when and why the income, and eventually the minerals themselves, will be dispersed to the beneficiaries.

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