Drawbacks of Royalty Trusts

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Drawbacks of Royalty Trusts

The downsides to royalty trusts include the following drawbacks.

Depletion, depletion, depletion

Royalty trusts own royalties on a finite amount of resources. Once those resources are gone, they’re gone. As the resources deplete, royalties and distributions will fall and will, eventually, go to zero. In financial terms, there is no terminal value. Granted, most trusts won’t hit this point for two or three decades (or more), but it’s still incredibly important to consider that distributions will eventually contract and disappear.

Volatile distributions

Trusts typically pay out their distributions on a quarterly or monthly basis. If royalties fall in that period due to the underlying commodity price tanking, distributions will also fall. It’s entirely conceivable that a trust that yielded 15% in the last 12 months could yield 3% in the next 12.

Tax-filing complexity

Owners of royalty trusts are required to report the pro rata portion of a trust’s total income and expenses on their tax returns. This typically means filing Schedules E and B as well as having additional work with Form 1040.

State income taxes

Owners of trusts are liable for paying income taxes in the states in which the trust generates its royalties. Different states have different thresholds for when taxes have to actually be filed and paid, and the likelihood of owing income tax in multiple states increases with the size of a given ownership position.