Tax Considerations for Royalty Trusts

Tax Considerations for Royalty Trusts

Royalty trusts are investment vehicles that allow you to receive income generated from certain types of energy-related assets, including oil wells and gas deposits, as well as mines and timberland. Investing in oil and gas royalty trusts has many unique features that affect the way you are taxed. A royalty trust will generate income until its resources are fully depleted, at which time the trust is dissolved.

Characteristics of a Royalty Trust

According to the royalty trust definition, this investment vehicle generates income from royalties paid to it by the owner of the income-producing assets associated with the trust. For example, an oil company owning a working oil field containing substantial deposits may wish to accelerate its return on investment. It enters into a royalty trust that allows investors to buy units in the trust in return for a prorated portion of the royalties paid by the oil company to the trust. This arrangement produces equity capital (the money invested in units) that the oil company can reinvest elsewhere, and investors receive monthly royalty income based upon oil output and oil prices. Once set up, a royalty trust cannot accept new investments and cannot purchase additional assets.

A royalty trust is a pass-through entity, meaning that it passes income and expenses through to unitholders and thereby avoids paying corporate income tax – all federal income taxes are collected from unitholders. The taxation of royalty trusts is somewhat complex, but offers certain tax benefits to investors.

Taxation of Royalty Income

Every month, a trust unitholder receives a cash distribution based on the royalties paid the previous month by the asset owner, such as the oil company. The monthly royalty payments are not fixed, but rather fluctuate with production output and the current price of the output. As a unitholder, you receive a gross payment based on the number of units you hold. You also receive pro-rated expenses incurred for the month that reduce your tax liability, including:

  • Severance tax: This is a tax imposed by the state(s) in which the income-producing assets are located.
  • Administrative expense: All the administrative costs associated with running the company that extracts the resources associated with the royalty trust.
  • Depletion: The cost stemming from the shrinking amount of recoverable assets due to the previous month’s extractions.    

The severance tax and administrative expense reduce the current tax liability generated by the gross income payments you receive. Depletion defers your current tax liability by reducing the cost basis of your trust units. The remaining tax liability is assessed at your ordinary marginal tax rate, not at the lower rate charged for stock dividends. When you sell your unit shares, you pay ordinary income on the total depletion credits your received and capital gains tax on the profit, if any, on the portion remaining after subtracting the depletion credits. Had the trust earned any interest income, it would be added to your gross income payment.

Example of Royalty Trust Taxation

Assume you have interest in buying oil royalty trust stocks. On March 1 of year one, you buy 1,000 units in an oil royalty trust for $6.11 a share, creating an initial cost basis of $6,110. You later sell the units on March 1 of year two. You are therefore entitled to monthly income for 12 months. For the period of March 1 through Dec. 31 of year one, your units provide you with $518 in gross income, generating $37 in severance tax and $13 in administrative expense, thereby reducing the taxable income to $468. During the period, cost depletion of $449 is recorded, further reducing your net income to $19, taxed at your marginal rate. You record all these facts on Schedule E of Form 1040. No interest income was produced, but if it had been, it would be recorded on Schedule B. You record your $19 of trust income on Form 1040 for year one.

For year two, you receive two months of income from the trust, which after subtracting severance tax and administrative expense, equals $76. Depletion for the period is $65, creating a net income of $11. Your total depletion for the one-year holding period is $449 + $11, or $460, reducing the cost basis of your investment from $6,110 to $5,650. Assume you sell your trust units for $5,900 on March 1 of year two, a gain above cost basis of $250 ($5,900 - $5,650) The sale produces the following year two tax liabilities:

  • You pay ordinary tax on the $11 of year two income and on the $460 of accumulated depletion, for a total of $471 of income taxed at your marginal rate.
  • You pay long-term capital gains tax on the $250 in profit from the sale of the shares.

Notice that by holding the shares for a year, you qualify for the lower long-term capital gains rate on your $250 profit. Further notice that in year one, you paid tax on only $19 of trust income, with taxes on the year one $449 depletion amount deferred to the subsequent tax year. You also may have to pay state income taxes on your royalty trust income, depending on where you live. The royalty trust will send you Forms 1099-MISC, 1099-INT, and for certain trusts, K-1, containing the income and expense figures you need to file your taxes.

Master Limited Partnerships

A master limited partnership (MLP) is similar to a royalty trust. It is a publicly traded limited partnership which sells units to the public. MLPs are used for energy investments, but often the assets owned, such as pipelines, are less price-volatile than those associated with royalty trusts. Like a royalty trust, an MLP is a pass-through entity that pays no tax on its own – that honor belongs to unitholders. The tax rules regarding depletion and income are very similar for MLPs and royalty trusts. MLPs differ from royalty trusts in several ways:

  1. MLPs are more flexible than royalty trusts. They have the ability to add assets, reinvest their income, issue new units and incur debt.
  2. MLPs report income and expenses on Form K-1.
  3. MLPs do not usually self-liquidate. Rather, they act as an ongoing business that is expected to survive. A royalty trust typically has a lifetime of 10 to 20 years.
  4. MLPs generate unrelated business income tax (UBIT), making them inappropriate investments for IRAs. When an IRA buys MLP units, it becomes a partner and thus “earns” the income it receives. The IRA will thus have to pay UBIT on the income, wiping out the tax advantage. Royalty trusts do not generate UBIT.
  5. MLPs can take on additional investors over time and can purchase or sell holdings. An MLP is run by its general partners, who are responsible for all administrative tasks.
  6. MLP yields are attractive, and while usually lower than those from royalty trusts, the yields are steadier due to the stable assets typically owned. Royalty trust unit prices vary directly with the income that will be produced, and that income is sensitive to the amount and price of output. An MLP invested in, say, oil pipelines, is less exposed to the volatility of oil prices, since they draw income from long-term leases.