Navigating the Michigan General Property Tax Qualified Agricultural Property Exemption

The Michigan General Property Tax grants two significant exemptions from the levy of taxes by school districts. They are the qualified agricultural property exemption, and the personal residence exemption (see, The Michigan Property Tax Personal Residence Exemption, in Michigan Estate Planning Blog). The agricultural exemption is obviously important to farm clients. However, the personal residence exemption is also important the two interrelate in some unexpected ways. It will be well for a farmland owner to familiarize her/himself with both exemptions and their quirks.
Exemption From School Tax
Both of these exemptions provide essentially the same relief from real property taxation; exemption from the school tax. Because the school tax is generally the largest of taxes levied in a particular locality, this is an important exemption. In the case of farmland owners, there is some real fairness to this in a land-value based tax system. A single farmer may own 100's or even 1000's of acres of land, all subject to Michigan's ad valorem land – based tax. A typical non-agricultural homeowner generally will own their home, but a fractional amount of acreage. Yet each has essentially the same statistical family, and therefore each sends the same statistical number of students through the local school system.
Classification
Land that is classified as "qualified agricultural land" in Michigan is automatically exempt from the school tax. With the personal residence exemption, the homeowner must qualify by demonstrating that they intend to live there permanently and must file an Affidavit of Personal Residence with the local assessor. The mere classification of land as residential has no bearing on the exemption (other than only residential classified land qualifies, of all other conditions are satisfied). An owner of qualified agricultural - classified land does not need to file anything. However, if the land is not classified by the local assessor as "qualified agricultural land," and the owner is conducting agricultural activities on it, there is authority under the statute for the owner to file an Affidavit. In the case where an Affidavit needs to be filed, it must be done by the same May 1, deadline as the personal residence exemption.
Ownership
Another difference between the two exemptions is that, unlike the personal residence exemption, the land may be owned by a corporation, partnership, LLC, Trust or similar entity and still qualify for the exemption. A transfer of farmland to one of these entities for estate or succession planning will not rescind or otherwise harm the exemption. However, the law indicates that if there is a personal residence on the agricultural property, the owner-occupant may not claim a personal residence exemption on another property.
The local assessor may allocate properties that are in "mixed – use," applying a percentage of exemption to the parcel. This can be tricky. The ad valorem tax nature of the tax means that the allocation must be made based on the value of the particular percentage of the property being used, rather than a straight geographical determination. In other words, a 40-acre parcel may have a commercial facility occupying 1 acre. It is not correct to assume that the parcel remains 98% (39/40) exempt. Rather, a fraction of the value of the commercial facility divided by the overall value of the 40 acre parcel would be the correct way to determine the amount remaining qualified and therefore exempt. This is a lot more subjective and perhaps lends itself to a certain amount of uncertainty and lack of clarity.
It is also problematic, in my view, that the guidelines published by the Michigan Department of Treasury ("State Tax Commission Qualified Agricultural Property Exemption Guidelines"), define "agricultural use," but they do not define other uses such as "commercial / industrial" use, even though they make reference to it. One question this leaves open to interpretation is what the effect is of incidental non-farm related use and how much and how often an agricultural facility must be used for activity (e.g., temporary storage of agricultural commodities for a commercial operator).
Practical Concerns
I
have often said here (and elsewhere) that farmers and farming are unique businesses and landowners. There are a lot of things going on with most farmland parcels. In addition to the "qualified agricultural property" tax classification, farmland is also often subject to Farmland Development Agreement Liens (so-called P.A. 116 Agreements), FSA agreements, wetlands agreements, and conservation easements. Transfer and conveyance of farmland often triggers issues regarding the Michigan Land Division Act, and "uncapping" issues.
More often than not these days, I find myself beginning my conversation with farmers in the "apology mode," explaining that unfortunately, what seemingly used to be relatively simple matters of the proverbial "quit claim deed," have now become very complex real estate transactions. I am not saying that all these rules, liens, taxes and exemptions make transactions unfeasible or impossible. But I am saying that it is important that all the proverbial "I's" and "T's" are dotted and crossed.
A
typical farm real estate transaction today involves analysis of many issues. In addition to correct legal descriptions and title evidence, we need to determine tax code parcel identification codes to see that they are accurate; P.A. 116 Agreement numbers (if applicable) and expiration dates, and whether a transfer is required; whether the proposed parcel transfer will itself qualify for P.A. 116; whether the transfer of a parcel involves a "division" or is exempt, whether a parcel contains a personal residence on which a personal residence exemption is being claimed; just to name a few of the issues. When transfers occur, we need to file a Property Transfer Affidavit and where applicable, an Affidavit of Agricultural Use to exempt the transaction from and "uncapping" transfer.
Unfortunately, gone are the days when a simple deed from one party to the other would suffice. Competent, experienced professional assistance needs to be sought when there are farm real estate transactions.

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Should You Convert Your Land Partnership to an LLC?

Since 1997, the Michigan Limited Liability Company Act has provided for an "automatic conversion" of Michigan Partnerships (both regular and Limited Partnerships) into a Limited Liability Company. Over the years, a lot of land-owners formed partnerships for various reasons, including succession planning, rent and tax considerations, and joint-ownership buy and sell provisions. In many (if not most) cases, there is little reason not to consider the conversion from a Partnership to a Limited Liability Company (LLC). There is a one-time filing fee for filing the Articles of Organization for the LLC, and an nominal annual fee and relative simple Michigan Annual Report. These are the only real changes to reporting and bookkeeping requirements. The organization will continue (in most cases) to file the Federal Income Tax Form 1065 (and MI 1065) with no substantial changes.

In return, the partners (now called "members") gain something pretty valuable—limited liability. Note that this limited liability only applies to incidents and occurrences after the conversion. You cannot use the conversion to "cure" a problem that arose prior to the conversion. In a traditional co-partnership, a partner is personally liable for all of the activities and liabilities of the partnership, even if it is one of the other partners who created the problem. Worse, a creditor can pick and choose which partner they want to pursue and can hold that one partner liable for 100% of the liability. The law takes the position that it is between the partners to allocate losses due to liability among themselves and not the problem of the creditor. Moving forward, the LLC form of business offers many opportunities to arrange the affairs and agreements among the members in some very flexible ways.

One concern about making the change is the so-called "domino-effect" it might have with all of the different facets of land-ownership. In most cases, there are mortgages, lease agreements, and often P.A. 116 Farmland Development Rights Agreements. The tax status of the property is also a potential problem.

Section 707 (5) of the Michigan Limited Liability Company Act provides that when an automatic conversion is done, the resulting limited liability company is "considered the same entity that existed before the conversion." The provision goes on to say that all the property rights of the prior partnership remain vested in the limited liability company. This means that on the record, nothing really changes. There is no requirement in the Act, other than the filing of the Certificate of Conversion (built into the Articles of Organization, if the proper form is filed), for filings, notices, or recording of new deeds. This should mean, as a legal matter, that no change in ownership, or transfer has occurred.

While it should be noted that specific situations are not directly addressed by the statute, the following concerns should be covered:

• Mortgage "Due on Sale Clauses" should not be triggered
  
• There should not be an "uncapping" for purposes of Michigan ad valorem real property taxes (while the Michigan Tax Tribunal has indicated that a transfer to or from a limited liability company is a "transfer" – and therefore an "uncapping" event – as a practical matter, the filing of an "Affidavit of Agricultural Use" generally cures that problem and unless there is a good reason not to, should probably be filed simply to take a conservative approach).
  
• A recent conversation with the Michigan Department of Agriculture informally confirmed that neither they nor the Michigan Department of Treasury require a transfer of existing P.A. 116 agreements upon an automatic conversion.
  
• Leases are rights in property and in accordance with the Act language, neither Lessor nor Lessee's rights and obligations should change or be effected by the conversion.
  
• Nor should Land Contracts, Purchase Agreements, Joint-ownership agreements, easements, licenses or any other property rights be effected by the conversion.
  
• The rights and liabilities of the Partners to each other should be essentially unchanged, and any Partnership Agreement should continue to be effective unless and until an new "Operating Agreement" is executed. Since banks and other third parties commonly request or require copies of the Operating Agreement, it may be advisable to either create a new agreement, or create one which "adopts" the existing partnership agreement.
  

  
  

As always, when dealing with legal matters, it is very dangerous to take a "one-size-fits-all" approach. Before making a conversion, it is critical that you consult with both tax and legal advisors to be certain there are no unintended negative consequences. For example, in some limited cases, if the Partnership/LLC is also the operating entity, certain third parties (notably the Farm Services Administration) may treat a LLC differently than a Partnership. That could have significant economic consequences. LLC's, by their statutory nature, can be very difficult to exit as an individual member, unless there are clear terms in the operating agreement. It is important to discuss all of these issues prior to making the conversion. As a practical matter, many of the Partnerships I work with have been in existence for many years, and it is often a good time to "dust off" the Partnership Agreement and revisit its terms anyway.

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Effective Estate, Succession and Business Planning for Farmers

Family Farm businesses are unique. Family farming may be the only industry where the owners live and work in the same place. Farm children grow up going to work with their parents every day. Many farm children ultimately become next-generation owners of the business.

But while they are family owned and oriented, most farming operations are also sophisticated and complex, capital intensive, multi-million dollar businesses. Farmers must be scientists, financial managers, personnel specialists, mechanics, and gamblers. They must also be well versed in land management, and government programs, including "Oil and Gas" lease issues and Wind and Alternative Energy leases and programs.

Family farm businesses are unique

Over nearly 30 years of representing family farm businesses, I have observed that an essential part of their success requires careful Estate, Business and Succession Planning. Because farm businesses are a mix of family and farming there are unique Estate Planning concerns that must be addressed. At the same time, because of the complexity of farm businesses, advisors must have a sound knowledge of the industry. Land use rules such as the Michigan Farmland Preservation Program (P.A. 116), the Michigan Land Division Act, the real estate and transfer tax rules for Agricultural property and homesteads, and Federal Land Programs need to be considered. When setting up a business entity such as a Corporation or Limited Liability Company (LLC), it is important to know not only what the tax consequences of such an entity will be to the farmer, but how federal and state government programs will treat them. It is also important to know how the Secretary of State will view the transfer of trucks and equipment within such entities. Finally, consideration must be given to ensuring that adequate and thorough insurance coverage will be maintained.

Every significant participant in the family farm should have a personal Estate Plan, including appropriate documents designating appropriate distribution of assets and management of their affairs in the event of incapacity. A good, comprehensive Estate Plan should include, where appropriate:

• Trusts,

• Wills,

• Durable Powers of Attorney and

• Health Care Designation of Patient Advocate

Every significant participant in the farming operation should have their own estate plan

Importantly, the advisor needs to truly understand how these tools should be integrated to coordinate with the overall business and plan.

In today's farm industry, it is not uncommon for a farm to have several entities which may own "operations," land-holding entities, equipment, and other valuable assets. Part of the plan may be to segregate or compartmentalize different assets or asset groups. This can help with the incremental transfer of assets to the next generation and can also result in more effective asset protection for the owners. Entities and related tools which should be considered are:

• Limited Liability Companies (LLC's)

• Corporations (often "sub-chapter S" corporations)

• Land Ownership Agreements

• Lease Agreements for Farm Land, Oil and Gas, Wind, and Solar energy

• Equipment Lease Agreements

Occasionally, more sophisticated arrangement, like Family Limited Partnerships and special trust arrangements may be called for, but most often they can be handled adequately with the above listed tools.

When planning to transfer assets to the next generation, there are numerous concerns that both generations have. These concerns can create tension between the participants before and during the planning process. However, experience teaches us that we are better off to address the concerns head on and have a plan in place than to simply bury our heads and "hope." The current owners are often concerned that the next generation is not ready to shoulder the significant responsibility, that their decision-making is often driven by less practical and more theoretical objectives. They are fearful of over-extension of debt and of decisions that are not informed by experience. The older generation often perceives itself to be more frugal than the younger generation.

The younger generation can at times feel unappreciated and feel that the older generation's hesitance is holding the operations back. And, often, they are not given any concrete assurance that they will eventually play a significant part and become an owner of the farming business.

Reality is often somewhere in between. Good succession planning will allow the older generation to transfer significant wealth to the younger generation, but retain substantial control over the operations. It can also assure desired income for retirement to the transferring generation. With proper planning, we can transfer wealth, reduce or eliminate taxation, and give the younger generation an incremental part in the business and—eventually—succession to ownership.

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Update on Farmland Development (P.A. 116) Situation

In March I blogged about Governor Snyder's proposed budget plan, which purports to eliminate all tax credits, in what he articulates as a "leveling of the playing field." Whether you buy that or not, it is clear that his approach is moving in that direction.

Last month, the new Michigan Corporate Income tax was enacted and signed into law by the Governor. Somewhat to the surprise of many of us, this new corporate tax is the primary significant new tax. While there are also adjustments to the credits allowed for certain personal income tax returns beginning in 2012, the proposal to eliminate the P.A. 116 credit was not part of the new legislation, except as it relates to corporate-owned farmland. The law recognizes a potential unfairness to corporations that have unused credits, and provides for an election to continue filing under the former "Michigan Business Tax" until they have exhausted their unused credits. This would, presumably, include P.A. 116 credits available to the corporation for land it owns.

It is very important not to confuse this with corporate farming operations, which are common in Michigan. Usually, these farming corporations involve some aspect of operations, only. They generally do not own land—or if they do—it is small parcels which house barns, elevator operations, offices, tool sheds, and the like. Unless the acreage is significant, it is probable that the benefit from the P.A. 116 credit alone is not enough to cause a taxpayer to elect under the old taxation scheme.

On June 30, Michigan Farm Bureau's Michigan Farm News reported that the Snyder proposals have yet to be introduced in the Michigan Legislature. Thus, at this point the proposal to eliminate the P.A. 116 tax credit program remains conjecture. However, numerous factors, including continuing state budget deficits, the current administration's views, and a currently supportive legislature, strongly suggest it may still be coming.

The "reprieve" does not appear to have impressed the majority of my farm clients. I am still being told by most of them that it is their intent to extend all their agreements, and enroll land that was not previously enrolled, at the earliest possible opportunity. Many have already officially made this request. We are currently assisting a number of others with that.

As I noted in my previous blog, the analysis has changed. Where many farmers previously "managed" the agreements for the shortest duration with a plan to extend periodically, today farmers are looking at how long the extension should be. For "legacy" operations, the consensus seems to be to extend to the maximum allowable duration (90 years from the time the land was originally enrolled). Others are trying to make the difficult prediction of how long the land might stay in agricultural production and whether they have heirs that will continue to maintain farming operations.

The MDA-Farmland division is significantly backlogged with extension requests. The Michigan Farm New article above, quotes Richard Harlow, director of the MDA-Farmland Program as saying they had received, over 10,000 contract renewal/extension requests already in 2011. He notes that in a normal year, they get round 3,000 annually. With a November 1 deadline in order to be eligible for 2012 credits, I expect this number to increase significantly. Do not expect a rapid turnaround. As far as I am aware, there has not been a significant increase in resources available to process these requests.

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Snyder Budget Targets Farmland Preservation Credits

Governor Snyder's proposed budget focuses on removing tax credits he regards as benefitting special interests. In my view, we all have our own special interests, and our economy is made up of many, many such special interests. In this case, the special interest is owners of farmland and open space land which is subject to (or could be subject to) a Farmland and Open Spaces Development Agreement. The act, so-called P.A 116, provides that qualifying lands can be enrolled in a program administered by the Michigan Department of Agriculture, for a period of years (generally from 10 years to 90 years). The agreement provides that such lands may not be developed or used for purposes other than agricultural production (or in the case of open spaces, left open or for recreational use) during the pendency of the agreement.

In return, the landowner is give a tax credit which is based upon the acreage enrolled and the "household income" of the landowner under Michigan's income tax law. The agreements also exempt the landowner from special assessments on the property for adjacent services during the term of the agreement. If the land is removed from the agreement at its expiration, a lien for the past 7 years of credit claimed is placed on the land and will become due upon the transfer of the land to another owner.

Conventional wisdom (well, mine, anyway J ) said that an agreement should be entered for the minimum period allowed and then extended for the minimum period each time (extensions could be a minimum of 7 years). However, if passed the Snyder budget (and subsequent enabling legislation) will change that convention. In a recent interview, the governor acknowledged that the existing agreements are a matter of contract to which the state is obligated. In other words, regardless of the result of the budget act, existing agreements will continue to be honored. This will include agreements due to expire in the future, no matter how far out into the future. However, it is probable that on passage of a new law in concert with the Snyder proposal, after some period of time (presumably as soon as November, 2011), new agreements will no longer be enrolled.

This gives rise to an interesting and different analysis. P.A. 116 allows a landowner who has a current contract to extend that contract. The contract may be extended at any time during the agreement. Now there is some incentive for farmland owners to at least consider extending their contracts for a longer term, in order to insure continued P.A. 116 credits. As well, landowners who have not yet enrolled their land in the program now have a potential looming deadline, as well as an opportunity to preserve the credits going forward. At the same time, any analysis should also include consideration about intended and potential future uses of the land. Once in the agreement, it will be very difficult, if not impossible, to remove the land from the agreement in order to sell or use it for purposes other than the production of agricultural crops or open space and recreation.

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New Estate Tax Laws Will Benefit Family Farm Succession Planning

Someone recently asked me if I believe in miracles. I do now! On December 17, 2010, after more than 6 years of inaction, bickering, hemming and hawing, Congress, suddenly and unexpectedly, miraculously acted to create what I believe is likely to become permanent change to the Federal Estate and Gift Tax Laws.

Acting to "extend" the so-called "Bush Tax cuts," for two years, the Congress actually enacted some wholly new provisions in the Tax Code relating to Estate and Gift taxes. While most of the "extension" will be, in my view, a "wait and see" proposition during and after the next 2 years, the Estate and Gift provisions seem to me to have set a "new bar" for certain provisions, from which it will be difficult, if not impossible, for Congress to turn back. In this season of "joy," I say Hallelujah!

I have been saying to clients for a number of years that aside from philosophical views on taxes and tax policy, what we really need Congress to do is just give us some law that is consistent. Planning requires consistency and some semblance of permanency so we can rely on our planning to work. So the new provisions come as a welcome surprise and relief. Many of us have been calling for some "common sense" provisions like a reasonable figure for the size of a taxable estate, and indexing for inflation. They did that. Wow! I write another blog (linked in the header above), the Michigan Estate Planning Blog, and back in February, I wrote a rather scathing (for me, anyway) scolding to Congress for its inaction and gridlock in the name of partisan politics. I recently posted a new Blog, jokingly suggesting that Congress read my Blog. They seriously seem to have addressed all of the items on my "wish list." The highlights of the new law are:

• The taxable estate figure (formerly known as "unified credit," now known as "exemption equivalent) has been set at $5 million
  
• The exemption equivalent was "decoupled" under the "Bush Tax cuts," so while the estate tax amount was increased and eventually (temporarily) eliminated, the Gift Tax amount was inexplicably frozen at $1 million. The new law reunifies this so that both figures are now set at $5 million.
  
• There is a new concept (referred to a "portability") which now allows a married couple to "share" their unused unified credit, I think effectively eliminating the need to create and maintain complex dual trust plans in many, if not most circumstances.
  

  
  

These developments are bound to help us in planning for farm families with multiple generations involved in the business. One of the big issues with agribusinesses is that they are generally capital intensive and cash poor. This means that while Uncle Sam is looking for payment of Federal Estate taxes on a multi-million dollar estate, the heir's ability to pay is hampered by the fact that the assets are capital which must be used in the operation. Giving us a $10 million threshold to work with will make family succession planning for family farms much more tenable.

At the same time, the portability feature will make lifetime planning simpler and therefore more effective, and will give added flexibility to make after-death adjustments to plans which may have been difficult or impossible under the old rules.

The nature of successful family farm businesses is that assets tend to continue to grow in value. Raising the Federal Gift tax threshold to the same $5 million mark as the Estate tax threshold makes lifetime gift planning much more effective, allowing substantial gift transfers of farm assets to the next generation before they appreciate significantly in value.

These new provisions were made retroactively effective as of January 1, 2010. In an uncharacteristic move, Congress not only made these fundamental decisions, but they anticipated some of the problems that might be caused by their inaction during the first 11 months of 2010. They appear to appreciate the potential unfairness of imposing a retroactive law people who had the misfortune to die before its effective date. For estates of individuals dying between January 1, 2010 and December 17, 2010, the administrators are given the right to elect between the prior 2010 law and the new law. And, in order to give these persons the time to analyze the effect of their election, the deadlines for filing Estate and Gift Tax returns and for making "qualified disclaimers" has been extended until 9 months after the December 17 date.

The details of the new provisions will undoubtedly come to light during the next several months and it will make for interesting times. Farm clients who have not done the Estate Planning they should do will now have an opportunity under the new laws to do so in a more palatable and simple manner. For those who have done their planning, this will be a great opportunity to review, upgrade and perhaps simplify their existing programs, while taking advantage of some of the new opportunities under the new rules.

We will likely be reporting on developments in the new law frequently over the next months. Stay tuned.

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Should You Sign that “Standard” Oil & Gas Lease?

Over the past 25 years, I have reviewed many Oil and Gas Leases brought to me by landowner clients. Usually they have been "printed" form documents and have mostly been similar if not identical, almost as if every developer was using the "same" form. The all reference, royalties, delay payments, bonus payments, and often "paid up" provisions. This phenomenon might lead one to conclude that there is a "standard" Oil Industry or Michigan Oil and Gas Lease Form.

The reality is that there is not, and has never been, a "standard" form. Oil and Gas activities are regulated by the State of Michigan, Department of Environmental Quality (DEQ) under Michigan's Natural Resources and Environmental Protection Act (MCL 324.61001 – 62103). While there are regulations and while the State leases lands for Oil and Gas (and has their own approve lease language), other than requiring certain provisions, the state has not mandated or approved any standard lease for.

Perhaps unfortunately, developers are left to their own creativity with written lease documents. You cannot rely on the fact that their form is printed and looks "standard." Many developers still use the anachronistic printed form lease language mentioned above. However, a number of them have become more creative, and some of the leases I have recently reviewed have made a broad leap from being an Oil and Gas lease to a much more general Resources Lease (even though generally still titled "Oil and Gas" Lease). It is also important to understand the most of the time, the person you negotiate the lease with is an independent agent (known in the industry as a "Landman"), either working for the developer, or independently and then selling or assigning the lease to an oil producer later. Consequently, you might ultimately be dealing with a completely different party than the party you originally negotiated the lease with. To avoid problems with oral communication and later misunderstanding, it is crucial that the written document be clear.

How Oil and Gas Leases Work

Traditionally, Oil and Gas Leases have two phases (referred to as "terms"), a "primary term," and a "secondary term." The primary term is usually a term of years (e.g., 5 years), and most often, involves the developer doing "exploration and testing" to determine if there is oil or gas in appropriate quantity on the premises. The "rent" for the primary term usually consists of a flat dollar-per-acre amount, and can be paid over the term, or can be paid all at once at the beginning of the lease term (the latter is referred to as "paid up" and is what I most commonly see in Michigan). This payment during the primary term of the lease is usually referred to in the lease documents as "delay rental payments," but is often colloquially referred to in the industry as the "bonus" or bonus amount.

The secondary term normally begins when actual production activity commences and payment is generally in the form of a percentage royalty on product that is removed. The Secondary term generally lasts as long as there is active production (and could continue for many years).

In the past, bonus amounts have been as low as a $10 flat fee for the entire parcel to $50 per acre. The customary royalty has been 1/8 of production, less the costs of the developer to remove and refine the oil or gas into usable form. And, in the past, there was usually little room to negotiate in most instances and these amounts were generally accepted.

The "New" Oil and Gas Lease

There has been remarkable change in the industry in recent years. The hugely increased worldwide demand for oil and gas, coupled with new measuring, explorations and drilling technologies, has created an upsurge in interest in farmland and other open land for oil exploration and production. In the past year, I have seen "bonus" amounts as high as $5,000 per acre (and have heard about even higher amounts), and well-informed land owners are negotiating the royalty. I have seen royalties of 1/6, or expressed as a straight percentage (e.g., 15%), without any reduction for the post-production costs mentioned in the previous paragraph! There is significant competition for lands which might either have oil or gas, or might become part of a "unitized" contiguous parcel which is or may be producing actively. Indeed, the motivation for many of the developers is to "tie up" the land so it cannot be leased by competitors or competing interests.

The key thought here, is that the landowner is today more than ever in a position to negotiate the lease and even to dictate terms. Landowners – particularly farmers – want to be able to protect their primary use of the land whether for cultivation, grazing, rental, or recreation. At the same time, if the oil and gas producer is going to make a tidy profit, the landowner certainly should share in that profit!

What You Should Look For in a Landowner-Friendly Oil and Gas Lease

When negotiating an Oil and Gas Lease, the landowner needs to keep in mind his or her interests. Of course, the primary consideration is continued, uninterrupted cultivation or other use of the land. In most cases, this means surface uses. Most developer-prepared leases do not thoroughly address these important landowner concerns. Nor do they, in my view, usually clearly define—and limit, where appropriate—the specific commodities being leased (and sold off the land). A Landowner-friendly Oil and Gas Lease should include, at a minimum, provisions that:

Clearly and precisely define what the minerals (oil, gas, and hydrocarbon related substances) that are being extracted. I recently reviewed a Lease that went well beyond this limited definition to include "other minerals" found and extracted. The problem was the "other minerals were not well defined. We took the position with the developer that if they found other minerals and wanted to extract them, we would negotiate at that time for additional lease payments or royalties, based on the quantity and value of minerals found (if we even wanted them extracted at all). Another issue that arises in nearly all Oil and Gas Leases is whether water can be extracted and used and what kind of water (e.g., fresh, brine, etc.) and in what quantities. It is also possible that the developer will inject brine into the subsurface, and the Landowner needs to consider their views about this activity. All these points should be specifically addressed in the written document.

Clearly and precisely define the activities permitted on the premises. Will the lease include the right to disturb the surface in any way? Will pipelines, power transmission lines, roads, pumping stations, tanks, or buildings be permitted? If so, it is important that the lease agreement reserve significant control over these things to the Landowner. These facilities must be constructed in a manner which is least likely to interfere with current or even intended future use of the land. Structures should be placed, to the extent feasible, at corners of parcels, near existing roads, and out of the way of the other potential uses. It is important that any underground facility be buried at "plow depth" (we prefer a specified depth – e.g., "not less than 48 inches" or similar language), and that above-ground facilities be thoughtfully placed (for example, it is imperative that above-ground structures be placed where they will not interfere with pivot-based irrigation systems). It is equally important that when any facility, road, or structure is place on the surface, that the landowner be additionally compensated (over and above the bonus and royalty) for the loss of that acreage from production. We recommend a Lease Provision that requires the developer to provide a site-plan for the Landowner's prior approval before any construction begins.

Clearly define those uses that the Landowner is reserving (which should be everything except the mineral rights being conveyed in the lease agreement). Lessees commonly want exclusive rights to certain physical attributes of the property so that they can exclude other uses which they think might interfere with their own use. However, the Landowner needs to be cognizant of the other opportunities available including wind leasing rights and telecommunication towers (and possibly solar rights in the future), as well as other mineral, gravel, sand, timber, etc., resources which might be sold from the property. The lease agreement should specifically reserve the right to the Landowner to lease and/or sell those items, so there is no misunderstanding in the future. Site plans and placement should also have in mind the possibility of wind and communications towers in the future.

For livestock farmers, it is important that the Oil and Gas Lease expressly provide for fencing and gating around surface facilities and structures, and that it provide clearly who is responsible for the fencing and gating.

Surface interference and Damage is clearly one of the primary issues to be negotiated and resolved. This includes siting issues as mentioned above, as well as the actual disturbance of the surface. If continued agricultural use is intended, a provision for separating and setting aside the topsoil should be part of the agreement. When laying underground pipeline or power conduits, the "double-ditching" method should be specified (requiring the producer to place topsoil on one side and subsoil on the other when trenching, and replacing subsoil first and then topsoil). Of course, modern trenching and equipment may obviate this need. The lease should also clearly provide for the producer to restore the surface to its original condition and at the end of the lease, to remove all surface equipment. The State of Michigan also has specific well closing and capping requirements and the lease should clearly provide for the Lessee's responsibility to comply with all state requirements.

Industry" Provisions

There are certain provisions that are generally found (or should be addressed) in virtually every Oil and Gas Lease. They should be reviewed and understood. Negotiation of these provisions will be circumstances driven. The following list is illustrative, but by no means complete :

• Pooling or consolidation refers to the producer combining your leased lands with (normally contiguous) land owned by other landowners that they have under lease. Michigan (as do most other states) has minimum acreage requirements for a single operation and for drill/pump spacing and has the statutory authority to require or order pooling in some circumstances. Most agreements also address voluntary pooling in the sense the producer may choose to pool lands over and above any state regulatory requirements. It is advisable for the Landowner to require in the lease that such "voluntary" pooling is subject to Landowner approval, rather than wholly at the producer's discretion, except to the extent that it must be done to comply with state requirements. Pooling can be a positive thing, as it may allow production and royalty payments to commence if there is production on some of the other pooled lands, and can also mean that your land could be under lease and never have any surface activity. However, the Landowner should retain some control over the pooling to insure limits on the numbers of acreage pooled, and the ability to sever land which has not been made part of the pool into a separate lease.
  
• Warranty clauses, requiring the landowner to warrant and defend title to the land and/or minerals are consistently found in the printed lease forms. They should be deleted. As a practical matter, the landmen or developer will do their own title searching and due diligence prior to executing leases.
  
• A Shut-in provision, allows a producing well to be stopped or shut down temporarily, usually for "reasons beyond the control of the producer." These provisions should be carefully reviewed and understood. They should provide for some kind of payment during the shut-in period, possibly accelerating over time, and for a limit on how long a well may be shut-in.
  
• "Mother Hubbard" Clauses provide that the lease covers any contiguous land owned by the landowner. This provision should be eliminated or tightly modified. They are commonly found in the "fine print."
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Can I Get More Money Than Is Being Offered?

Clearly, the bottom line here is whether the lease payments justify tying the property up. So, how much can you expect to be paid? The obvious (and lawyerly) answer is: it depends. There are certain formations that have been determined to have significant production or capability. If your land is in one of those formations, you can expect not only command higher payments, but to have greater negotiating leverage. If your land is in more "marginal" areas, you can expect lower payments and less willingness on the part of the lessee to negotiate the terms of its form lease. In other words, the proverbial statement, "your mileage may vary" applies here. There are, however, some points to keep in mind when considering entering an Oil and Gas Lease.

As a general rule, the longer the primary term of the lease, the higher the "delay payment" should be. The landowner should try to keep the primary term as short as possible. Any options to renew should come with new delay payment obligations, possibly accelerating for each new renewal option. The primary term will be extended to the (possibly unlimited) secondary term if active production is established. Obviously the definition of "active production" is very important.

Both delay payments and royalty payment provisions, particularly in a "hot" area, should be carefully considered. What is the "going rate" being paid for similar tracts? In addition to word-of-mouth and information from the potential lessee, there are resources, such as the Michigan Oil And Gas Association (remember that they represent the producer), the Michigan Department of Environmental Quality (DEQ), The National Association Of Royalty Owners (NARO), which represents landowners, which can provide information and links to other sources of information.

Calculation of royalty payments is an important consideration. Stating the royalty in terms of a fraction or percentage is only part of the equation. How that payment is calculated is equally important. The percentage can be set in terms of the "market price" at the well head, or in terms of the actual price received for the product. It is also possible for the Landowner to receive payment "in-kind." Normally, the Landowner is not equipped to market crude oil, so this is generally more common for natural gas and usually limited to quantities the Landowner would use personally.

Perhaps more important to the calculation is at what stage of production the royalty payment is applied. Traditionally, the producer would offer a 1/8 royalty, minus certain post production costs. Those costs can be substantial and as noted earlier, include items which are really not true "costs." More importantly, if the producer is getting the majority of the payment for the end product, it would seem more appropriate for them to bear the post-production costs. These provisions should be carefully reviewed and the Landowner should firmly negotiate for a "gross" payment. In the process, there may be some costs which will be agreed upon; usually they are taxes which it does seem appropriate for the Landowner to share.

In the context of a (albeit rather long) Blog post, it is impossible to cover all the concerns and probabilities. It should not come as any surprise to the reader that I strongly recommend that any offered Oil and Gas Lease agreement be reviewed by counsel who is qualified to review and counsel on these issues.

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