The Secret to Finding 39.41% Yields

David Fessler By David Fessler, Energy and Infrastructure Strategist, The Oxford Club

Oil & Gas

Here’s an income idea that too few investors are aware of…

As regular readers know, I’m a big fan of midstream master limited partnerships.

Why? I believe midstream MLPs are simply the best “total return” vehicles available to the average investor today.

By total return, I mean the combination of the growth of the underlying shares (or units in the case of MLPs) plus income.

MLP income is in the form of quarterly distributions. They are similar to dividends.

These payouts are generally higher than those coming from a non-MLP company. This is due to special tax advantages that I’ll cover in a moment.

There are currently 140 MLPs. They have yields ranging from 0.33% to 39.41%.

You may be reluctant to invest in MLPs. You may have heard they differ from normal stocks.

They do. There is a little more work involved during tax season. However, it’s well worth the effort.

In this two-part installment, I’ll cover the ins and outs of MLPs. I’ll show you how they’re structured.

I’ll explain their tax differences. Most importantly, I’ll show you their advantages over regular stocks.

If you choose carefully, MLPs can provide you with double-digit growth and income. Let’s get started.

MLP 101

What is an MLP? It’s a different kind of income-oriented equity than most investors are familiar with. It provides unique advantages to investors. At the same time, it retains the safety and simplicity of publicly traded stocks.

MLPs are subject to the same reporting, accounting and oversight rules as publicly traded corporations. MLP units trade on all major U.S. stock exchanges.

They have the same liquidity as regular companies. There are a few differences, though.

MLPs are valued differently than regular corporations. They have exceptionally large noncash expenses, such as depreciation.

Traditional earnings-based metrics really don’t apply to MLPs. This can be confusing because some news outlets insist on reporting them that way.

MLPs are valued by the size, sustainability and growth rate of their cash distributions. If an MLP’s dividend isn’t growing or sustainable, it’s a red flag for investors.

Why invest in MLPs? MLPs generally provide a better return than traditional dividend-paying corporations.

As you can see, the yields of the S&P MLP Index have outperformed those of the PowerShares High Yield Equity Dividend Achievers Portfolio by 128.4% over the past five years.

That’s because an MLP’s distributions are tax-deferred. This differs from regular corporations that pay tax on their income and then the shareholders pay tax on their dividends.

Distributions to unit holders aren’t taxable. So there’s no “double taxation” with MLPs.

The fundamental differences between MLPs and corporations are their structure and tax treatment by the IRS. MLPs are obligated and encouraged to distribute more than 80% of their “available” cash to unit holders.

Sticking It to the Taxman

MLPs are limited to nonrenewable natural resources, and the infrastructure and marketing required to deliver them. MLP activities include exploration, extraction, transportation, storage and wholesale marketing.

Unlike regular corporations, MLPs don’t pay taxes. All income and deductible expenses pass through to unit holders.

This gives unit holders exceptional tax and income advantages. At tax time, unit holders report partnership income via their K-1 forms.

In a regular corporation, a shareholder is a part owner of a separate, taxable legal entity. An MLP unit holder is the taxable entity and limited partner.

Corporate shareholders receive a portion of after-tax income in the form of a dividend. MLP unit holders get a share of the actual business income and expenses.

In the corporate format, the corporation itself pays tax on its income. MLP unit holders are the only taxable entities of an MLP.

As such, unit holders receive a share of the partnership’s income and tax benefits. They also must report any liabilities that come with those benefits.

A League of Their Own

Another significant difference between MLPs and regular corporations is their organization. All MLPs have a sponsor.

The sponsor provides assets to the limited partnership in exchange for ownership. The general partner (if there is one) has board and management control of the limited partnership.

The limited partner (unit holder) owns exchange-traded units. They have a passive interest with ownership rights to distributions.

Of course, the best part for investors – as I laid out earlier – is the high yields paid by a successful MLP. And as an added bonus, those yields are tax-deferred for the unit holder.

How do we select MLPs to invest in?

We’ll take a look at that in Part 2 of my article. Look for it in Energy & Resources Digest next week.

Good investing,

Dave