Tax 6878 Investing in Royalty Trusts Summary

TO: Investment Club Members

FROM:

DATE: May 26, 2013

SUBJECT: Investing in Royalty Trusts

Included is a summary of the article “Tax and Investment Planning with Royalty Trusts,” by Richard B. Toolson, Debra L. Sanders, and William A. Raabe. The following includes the details needed to make a decision to or not to invest in a royalty trust. For assistance, this summary includes explanation on what a royalty trust is, the benefits, how they the trust is taxed, and where units should be placed for the best tax advantage.

What is a Royalty Trust?

A royalty trust is an entity which is involved in the profit interest of natural resources. The capital acquired from selling beneficial interests of the trust are used to purchase the natural resource royalty interests. The profits of the royalty trust are not taxed at a corporate level; rather the unit holders receive distributions and are, then, taxed at the individual level.

All net cash flow is distributed to the unit holders. In most cases, a royalty trust earns a high yield of return because distributions usually exceed allocated income. In addition, any depletion allowance reduces the tax basis to be recaptured as ordinary income when the unit is sold.

Having an interest in natural resource properties, allows for diversification of an investor’s portfolio. These properties are a hedge against inflation because, as gas prices increase, the royalty trust’s value should increase. Negative attributes are that the resources are finite and will deplete over time. Also, distributions are not guaranteed. The distributions may vary depending on the price of the resource to which the trust is invested.

In order to predict future returns, the primary variables can be researched. Those variables include: current yield, remaining reserve life, and the future price levels of the natural resource.

Benefits to Using a Royalty Trust

Corporations use royalty trusts for two main reasons. The first, it allows the corporation to create capital more than would financing. Second, it allows a corporation to avoid AMT (alternative minimum tax).

Taxation

A royalty trust is classified as a grantor trust. This is the case because the unit holders are considered both the grantors and the income beneficiaries.

Investing in Royalty Trusts

May 26, 2013

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The proportionate share of all income and deductions of the trust flow through to the unit holder’s personal return. The allocations received include royalty income, administration expenses, severance taxes, depletion, and credits.

Depletion