Royalty trusts provide investors with both potential cashflow and tax benefits. This article explains how such trusts work and their tax consequences.
Royalty trusts offer income-oriented investors the opportunity to invest in natural resources, realize cashflow from these sources and reap tax benefits afforded the natural resource industry. By combining the modified passthrough tax regime of subchapter J with full, current income distributions, these trusts can provide investors with good liquidity and diversification, along with other Federal income tax advantages. This article explains both the investment and tax attributes of royalty trusts.
A royalty trust is a legal entity established as income-producing vehicle to purchase royalty interests (profit interests) in mature, low-risk natural resource (e.g., oil and gas) properties. (1) The trust sells beneficial interests (trust units) to investors (unit holders) to acquire capital for the trust. It then uses this capital to purchase natural resource royalty interests. It receives royalty income and distributes all of it, less management fees, to unit holders, either monthly or quarterly. A trustee, typically a bank, is appointed to provide administrative services. Royalty trusts have neither physical operations nor employees.
Because the entity functions as a simple trust in most tax years under the subchapter J rules, it is not subject to income tax and, thus, provides a tax-efficient way to distribute royalties to unit holders. Royalty trusts are neither debt nor stock, although they have some of the characteristics of equities. For example, trust units trade on organized exchanges (such as the New York Stock Exchange) and have the same type of market liquidity as stocks. Like publicly waded corporations, they register and file periodic reports with the SEC. (2) Royalty trust income is portfolio income for Sec. 469 purposes. (3)
A royalty trust distributes all of its net cashflow to unit holders; thus, under subchapter J, it has no Federal income tax liability. Any available depreciation and depletion deductions are allocated proportionately to the income beneficiaries, sheltering a portion of the year's distributed income. Thus, the cashflow available for distribution to unit holders generally exceeds the income allocated to them. As a result, royalty trusts normally earn a high yield.
Any depletion allowance allocated to investors reduces the tax basis in their investment; thus, the cash distribution shielded by the depletion allowance is deemed a return of capital and is tax deferred. Like equities in general, when units are sold, they are generally accorded capital gain or loss treatment. However, under Sec. 1254(a)(1), the depletion allowance is recaptured as ordinary income when the unit is sold.
Risk and Return
Diversification reduces a portfolio's riskiness, a desirable outcome for most income-oriented investors, who often are risk-averse. A commodities investment offers investors an opportunity to further diversify their portfolios, because commodities normally are deemed to be a distinct asset class whose returns do not correlate with traditional stock and bond investments. Moreover, they provide a hedge against inflation. A royalty trust that derives its income from natural resources can represent a pure investment in commodities. For instance, the unit price for a royalty trust with an interest in gas wells is tied directly to the underlying price of gas. As the price of gas increases, the royalty trust's value would also be expected to increase. At the same time, the investor avoids the exploration risk present with integrated oil companies.
A royalty trust is a claim on finite resources, albeit long-lived ones whose lives may last for two or three decades or more. As the resources are depleted, distributions will eventually fall to zero. In essence, distributions are, in part, a return of an investor's original investment, much like an annuity whose payout is partly a return of capital and partly a return on capital. Unlike dividend payments, the level of which is normally stable from year to year, royalty trust distributions are not guaranteed--they will vary depending on the price of the underlying natural resource. For example, Exhibit 1 below shows annual distributions of a large oil royalty trust, BP Prudhoe Bay Royalty Trust (BPT), since its formation. It illustrates the considerable annual fluctuation in distributions, which have varied from $0.57-$4.05/unit. At the beginning of 1999, the price of a barrel of crude oil was $8.64: for that year, BPT distributed only $0.57. In contrast, at the beginning of 2004, a barrel of oil cost $30.87; for that year, the trust paid $3.82. (4)
Unfortunately, there is no readily available index that tracks royalty trusts' aggregate historical returns. However, current track records for several publicly traded royalty trusts show that such trusts generally have excellent long-run returns (such as San Juan Basin Royalty Trust, which owns interests in gas wells located in the San Juan basin area of northern New Mexico).
Predicting Future Returns
Estimating future rates of return for any speculative investment invariably involves uncertainty, because of the difficulty in assigning accurate numbers to the variables. However, for royalty trusts, these estimations arguably involve less guesswork than for traditional equities, because it is often easier to assign amounts to the variables that determine the returns. The primary variables are the (1) current yield, (2) remaining reserve life (derived from...