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Investing: Master Limited Partnership: Don't Fear A K-1

Aug 17, 2007
It's tax time again! This is the time that we anxiously watch our mailboxes for the arrival of the documents we need to complete our income taxes. For most, their interest income is reported on a 1099. Other investments, such as partnerships, generate a K-1. Many think a K-1 complicates your taxes and should be avoided. I disagree. Read on to find out why.

There is a whole class of investments that has been avoided by income-oriented investors for many years. They are called Master Limited Partnerships, or MLPs. Owning them is more involved than owning a common stock, but the increased cash-flow makes it well worth it.

While most stock-based investments are issued by companies organized as corporations, MLPs are referred to as pass-through entities. Without going into too much detail, the main difference is that dividends from corporations are taxed at the corporate level and then at the investor level. MLP cash-flows are only taxed once, at the investor level.

You don't have to pay taxes each year on the cash-flows generated by MLPs because they are typically considered return of principal. That's because the tax code allows companies to amortize or depreciate money that is invested in an asset. Pass-through entities, like MLPs, allow those tax deductions to pass through to the investor.

You may think that a company isn't making any money if they don't have to pay taxes. But there is a difference between cash flow and profit. If a company invests money into a drilling rig, for example, it can amortize that expense over many years. So each year that write-off is viewed by the IRS as an expense.

The amount deducted for tax purposes 'shields' the equivalent amount of income from taxes. If a company has $1,000,000 left over each year after paying all its bills and has $1,000,000 in amortization, then it doesn't owe any taxes.

When a payment is considered return of principal, the amount you have invested for tax purposes (your cost basis) decreases by the same amount. When you eventually sell the investment you will have to pay capital gains on the difference between the sales price and your cost basis.

So, in effect, you are pushing the taxes down the road to when you sell the investment. But since capital gains are currently taxed at a lower tax rate, you end up paying less overall in taxes than you would if it were considered interest instead.

Even those in lower tax brackets can benefit from MLPs, because their yield can be much higher than other investments. If you want to maximize the level of income you can earn, MLPs may be just the thing for a portion of your money.

For instance, Ferrell Gas Partners (FGP) is the local propane company here in northeast Tennessee. When I purchased it for my clients a couple of years ago, it was paying a 10% dividend. Even though the price of their shares fluctuates, the dividend has remained steady quarter after quarter. Since that 10% is return of principal they haven't had to pay any taxes on it.

Kinder Morgan Energy Partners (KMP) is another example. It hasn't had a dividend cut since it started back in 1992. Moreover, their dividend continues to increase. When splits are taken into account, its dividend has increased from roughly 8 cents a share in 1992 to over $3.20 per share now. That's rising, tax-advantaged income.

I'm not recommending you rush out and buy either of these companies. You should research many MLPs before making an investment. I also recommend dividing the MLP portion of your portfolio between several companies to reduce your risk. Don't just choose the ones with the highest dividend yield, because it can be reduced in the future. Instead find a MLP that has a history of growing the company and increasing the dividend.

Receiving a K-1 does make doing your taxes slightly more difficult. You don't receive them as early as a 1099 so you have to wait longer to do your taxes. The popular tax software currently available handles K-1's just as easily as it does 1099's, so you are still able to do your own taxes. Also, MLPs are designed to be used in after-tax accounts and should not be purchased in an IRA.
About the Author
Nationally-syndicated financial columnist and Certified Financial Planner Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He will answer your financial question FREE at http://www.guardingyourwealth.net/
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