oyalty trusts provide income-oriented taxpayers with opportunities to invest in natural resources, realize cash flows and participate in the tax benefits afforded this specialized industry. To educate interested clients, CPAs should familiarize themselves with this type of investment.
Corporations owning natural resources create royalty trusts to raise capital, generate tax benefits or avoid tax burdens (for example, the alternative minimum tax). A royalty trust is a legal entity that purchases profit interests (interests that pass through profits, but not losses) in mature, low-risk, natural resource working properties (such as oil and gas). It sells beneficial interests (trust units) to investors to raise capital and distributes royalty income to unit holders, net of management fees.
Royalty trusts promise high yields when compared with traditional equity investments and typically return no less than good quality bonds do. While their prices fluctuate, they currently provide about a 9% return (on an annualized basis).
In addition to providing unit holders with income from the working property, the trust passes through proportionate shares of any depreciation or depletion deductions or tax credits to which the underlying property is entitled. Trust units are publicly traded and readily marketable, and generally trigger capital gain or loss on a subsequent sale (although depletion deductions may have to be recaptured at ordinary income rates). The trust itself is not taxed.
For the risk-averse investor, royalty trusts offer diversification and a pure investment in commodities; they reduce a portfolio’s overall risk and provide a hedge against inflation. For example, the unit price for a royalty trust with an interest in gas wells would be tied directly to the underlying price of gas. As the price of gas increases, the value of a trust unit would be expected to increase. At the same time the investor can avoid dealing with the exploration risk that would be present with integrated oil companies.
Normally, a royalty trust investment should be made within a retirement account to shelter the flow of current income against taxes, as long as the investment is intended to meet future retirement needs and retirement account contribution limits are not a concern. On the other hand, if the investment is intended to meet short-term goals (particularly an immediate need for retirement income), the trust units should be purchased via a taxable account. The tax analysis must be balanced against the unit holder’s risk tolerance and current need for cash.
Royalty trusts offer a combination of investment and tax incentives. For the income-oriented investor who can withstand value fluctuations, they can be a good source of cash flow and a way to enjoy directly the tax benefits afforded to natural resources. This combination of attributes makes the royalty trust an attractive investment device.
For more information, see Toolson, Sanders and Raabe, “Planning for Royalty Trusts,” in the August 2005 issue of The Tax Adviser.
—Lesli S. Laffie, editor
The Tax Adviser
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