MLPs

Now that you understand the concept of return of capital, let’s examine Master Limited Partnerships (MLPs). An MLP is a company that has a special structure that bypasses corporate taxes because it passes along (nearly) all of its profits to its shareholders in the form of a distribution.

These distributions are treated as return of capital by the Internal Revenue Service so investing in MLPs can be a tax-deferred strategy for generating income. As we discussed in the section on closed-end funds, the return of capital lowers your cost basis.

I’m simplifying things with this example, but if you bought an MLP at $25 per share and for ten years received a $1 per share distribution that was all return of capital, your cost basis would be reduced to $15.

Over those ten years, you would not pay taxes on those $10 in distributions ($1 × 10 years). However, when you go to sell, you will pay a capital gain tax on the difference between $15 and the selling price.

Talk to your tax professional before investing in MLPs, because the tax implications can be complex. Additionally, you receive a K-1 tax form from the company, which is different than the 1099-DIV that you get from regular dividend-paying companies. This can add to the cost and timeliness of your tax preparation.

About 80% of MLPs are energy companies. Most of them are oil and gas pipelines that aren’t impacted much by the price of oil or gas. Their business relies on volume of product that flows through its pipelines.

Other MLPs include infrastructure companies, financial firms, and even a cemetery operator.

MLPs are popular with income investors due to their strong tax-deferred dividends. The risk is that since all of the company’s profits are distributed back to shareholders, any decrease in earnings can result in a dividend cut. Although the dividend is high, it is usually not as stable as a strong dividend player like Clorox, which pays out only 54% of its profits in dividends and has raised its dividend for 34 consecutive years.

Kinder Morgan Energy Partners (NYSE: KMP) and Enterprise Product Partners (NYSE: EPD) are examples of two popular MLPs.