A Short Analysis Of Tax Considerations For Oil and Gas Royalty Trusts
Royalty trusts are investment vehicles that get you a consistent income from specific energy-related assets, like oil wells and gas deposits, apart from mines and timberland. Investing in oil and gas royalty trusts has some special characteristics that impact the way you are taxed. A royalty trust will continue to generate income up until its resources are completely depleted, and finally, the trust is dissolved.
Characteristics Of Royalty Trusts
A royalty trust is an investment vehicle that generates income from royalties, paid to it by the owner of the income-generating assets linked with the trust. For instance, an oil company owning an operational oil field having sizeable deposits may want to expedite its return on investment. It gets into a royalty trust that lets investors buy units in the trust in exchange for a prorated part of the royalties paid by the oil company to the trust.
This pact generates equity capital i.e., the money invested in units that the oil company will reinvest in another place. And investors receive regular royalty income depending on the oil production and oil prices. Once put in place, a royalty trust is not allowed to accept new investments, and/or buy additional assets.
A royalty trust transfers income & expenses to unitholders and by doing so evades paying corporate income tax. This means the unitholders pay all the federal income taxes.
How Royalty Income Is Taxed
The taxation of oil and gas royalty trusts is a bit complicated but offers some tax benefits to investors.
A trust unitholder receives a cash distribution depending on the royalties paid by the asset owner, like the oil company. These royalty payments tend to fluctuate according to production output and the current price of the output. As an unitholder, you receive a gross payment calculated according to the number of units you hold. You additionally receive prorated expenses incurred in a month reducing your tax liability, including:
Severance tax. Tax levied by the state where the income-generating assets are located.
Administrative expense. The entire administrative costs, related to operating the company that extracts the resources linked with the royalty trust.
Depletion. The cost arising from the depleting recoverable assets owing to the previous month’s extractions.
The severance tax along with administrative expense decreases the existing tax liability created by the gross income payments you are receiving regularly. Depletion puts off your present tax liability by decreasing the cost basis of your trust units. The rest of the tax liability is assessed at your normal marginal tax rate, instead of the lower rate levied on stock dividends.
If you sell your unit shares, you pay standard income tax on the total depletion credits you have received. And capital gains tax on the profit, on the part left after subtracting the depletion credits. In case the trust earned interest income, it is added to your gross income payment.
The Bottom Line
If you are looking to diversify your investment portfolio, then oil and gas royalty trusts are worth considering. However, you should take a steady approach in the beginning.
