Royalty Income Trust

What Is a Royalty Income Trust?

A royalty income trust is a type of special-purpose financing vehicle that lets investors partake in income generated from gas deposits, oil wells, coal mines, and other energy-producing concerns. As long as these companies remain operational and continue moving product, 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.

Understanding Royalty Income Trust

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 which 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.