What Is a Royalty Income Trust?
A royalty income trust is a type of special-purpose financing vehicle that lets investors partake in the income generated from gas deposits, oil wells, coal mines, and other energy-producing concerns. They are most often found in Canada.
As long as these companies remain operational and continue moving products, trust unitholders receive monthly cash distributions based on royalties paid by those companies during each prior month. Once a natural resource is depleted; say, an oil well runs dry, the trust is immediately dissolved.
Key Takeaways
- A royalty income trust is a type of special-purpose financing vehicle that lets investors receive the income generated by energy-producing companies, usually seen in Canada.
- Investors, who are known as unitholders, receive monthly cash distributions based on the royalties paid by the companies during the prior month.
- Royalty trusts offer investors higher yields than stocks, even though they trade alike.
- Royalty trusts offer tax-advantaged yields to investors because the IRS doesn't recognize distributions from these vehicles as taxable events.
Understanding Royalty Income Trusts
Royalty trusts offer investors the promise of higher yields than stocks, even though they trade similarly. These trusts attract energy companies because they let them sell their cash-flow-producing assets for relatively high prices.
Consider the following fictitious example: Suppose ABC Oil Company anticipates selling one million barrels per year for the next 20 years, for $20 per barrel, thus earning $20 million per year. ABC may elect to partner with an investment bank to sell its oil output to a royalty income trust. Moving forward, ABC receives a routine payout from the bank, which, in turn, distributes ABC's profits to unitholders. An investor's monthly take fluctuates depending on the output of ABC's production and the current price of said output.Simply put, this arrangement locks in reliable earnings for ABC, while potentially reaping high returns for unitholders.
Additional Benefits of Royalty Income Trusts
As pass-through entities, royalty income trusts avoid corporate income tax liability by passing expenses and income to unitholders, who enjoy tax-advantaged yields, due to the fact that energy companies depreciate over time and because natural resources inevitably deplete. Consequently, the IRS doesn't recognize distributions from most royalty income trusts income as taxable events. Instead, unitholders may use these distributions to reduce their cost basis in the stock, which is taxed at lower capital gains rates and is tax-deferred until investors liquidate their positions.
Furthermore, in some cases, investors may enjoy modest tax credits if they hold units in trusts whose companies produce clean and renewable energy.
Risks Associated With Royalty Income Trusts
The cash flows from royalty income trusts are subject to the notoriously volatile commodities prices and unsteady production levels—uncertainties that present a certain degree of risk for investors. Furthermore, royalty trusts themselves have no physical operations, as they're merely financing vehicles run by banks.
Consequently, unlike traditional stock investors, unitholders interface strictly with the banks and are removed from the energy companies behind the trusts. This gives investors little influence over operational decisions that may affect a company's bottom line.
After a royalty trust is created, it is forbidden from taking on new investments.
FAQs
Royalty trusts offer investors higher yields than stocks, even though they trade alike. Royalty trusts offer tax-advantaged yields to investors because the IRS doesn't recognize distributions from these vehicles as taxable events.
What are the risks of a royalty trust? ›
Royalty trusts come with risks, including income variability due to commodity price fluctuations and resource depletion. They lack control over asset management and face management risk. Tax complexities and uncertainties in closure are also associated risks.
What happens when a royalty trust terminates? ›
What happens when the Trust terminates? Once the decision has been made to terminate the Trust, the Royalty Properties will be sold for market value and the cash received from the sale less any applicable administrative costs will be distributed to the Unitholders of record at that time.
What is the royalty income? ›
The amount someone pays you to use your property, after you subtract the expenses you have for the property. Royalty income includes any payments you get from a patent, a copyright, or some natural resource that you own.
How to get royalty income? ›
Investors can acquire rights to royalty income by purchasing shares of royalty trusts or bidding on royalty auction exchanges. If you're thinking about investing in royalty income, you may want to speak with a financial advisor first. SmartAsset's free tool can match you with advisors that serve your area.
What are the benefits of a royalty trust? ›
Royalty trusts offer investors higher yields than stocks, even though they trade alike. Royalty trusts offer tax-advantaged yields to investors because the IRS doesn't recognize distributions from these vehicles as taxable events.
What is the disadvantage of royalty? ›
Being royalty can come with drawbacks such as limited privacy, intense public scrutiny, and the burden of societal expectations. The loss of personal freedoms, constant media attention, and the pressure to maintain a certain image can contribute to a challenging and restrictive lifestyle.
What are the three ways a trust can be terminated? ›
Natural Trust Termination
- Upon the settlor's death. Upon the death of the settlor (or within a reasonable time after death) a standard liquidating trust may terminate. ...
- Upon another stated event. ...
- Upon conclusion of maximum legal term.
The leftover property is known as the trust “residue.” Trustees can discuss these assets with beneficiaries to determine which beneficiaries want them to be included as a part of their share of the trust estate.
Can you own a royalty trust in an IRA? ›
A self-directed IRA is used mainly for investing in other investment opportunities typically not allowed by IRA custodians. They include but are not limited to, royalty properties and oil and gas mineral rights.
These deductions include interest, taxes, depreciation, repairs, etc. To be attributable to rent or royalty income, an expense must be directly incurred, in an accounting sense, in the rental of property or for the production of royalties (S. Rep.
Do I have to pay taxes on royalties? ›
Royalties from copyrights, patents, and oil, gas and mineral properties are taxable as ordinary income. You generally report royalties in Part I of Schedule E (Form 1040 or Form 1040-SR), Supplemental Income and Loss.
How long are royalties paid? ›
In general, song royalties do not expire. Copyright law protects musical compositions for a long duration, often the life of the creator plus an additional 70 years or more, depending on the jurisdiction.
How do you prove royalty income? ›
Royalty Payment Income
- royalty contract, agreement, or statement confirming amount, frequency, and duration of the income; and.
- borrower's most recent signed federal income tax return, including the related IRS Form 1040, Schedule E.
Royalties should be recognized as the underlying sales or usages occur, as long as this approach does not result in the acceleration of revenue ahead of the reporting entity's performance.
Who is entitled to royalties? ›
Book royalties: Paid to authors by publishers. Typically, the author will receive an agreed amount for every book sold. Performance royalties: The owner of copyrighted music receives an amount whenever the music or song is played by a radio station, used in a movie, or otherwise used by a third party.
Why is royalty worse than equity? ›
Equity is the representation of the ownership in the company. However, royalty gives only the right to use the property for a period specified, as per the agreement, between the parties. It does not provide the right to the company to own an asset.
What are the bad things about trust funds? ›
The major disadvantages that are associated with trusts are their perceived irrevocability, the loss of control over assets that are put into trust and their costs. In fact trusts can be made revocable, but this generally has negative consequences in respect of tax, estate duty, asset protection and stamp duty.
What are some of the drawbacks of investing in a unit trust? ›
Limited control – Your investment is entrusted to a fund manager, so performance levels can depend on their level of expertise and experience. Capital risk – Like all investments, there is a chance you could lose some or all of the initial capital invested in a unit trust.
Is it smart to invest in royalty? ›
Royalties can provide steady, stable, long-term income to investors. Royalties are generated by many types of assets, including musical compositions, oil wells, gold mines, books, movies and TV shows. As passive income, royalties are taxed at lower rates than wages and salaries.
