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.
WHAT ARE THEY?
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.
WHY INVEST?
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.
TAXABLE OR RETIREMENT ACCOUNT?
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.
CONCLUSION
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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