What do Burger King (USV $14.50), Williams Energy (WEG $34.86) and Boston Celtics (BOS $10.40) have in common? They have all listed their assets on the stock exchange as Master Limited Partnerships. (The above are not recommendations and are used solely to illustrate this concept).
When investors hear the words “Limited Partnerships,” they often picture some of the notorious tax schemes of the 1970s and 1980s. You’ve probably read about them—the ones that were illiquid, lost money, and made IRS agents grin. That’s not what I want to discuss, but rather, to tell you about a type of investment that uses some of the tax benefits of a limited partnership but with a few added twists.
One of the attractions to limited partnerships is their ability to avoid corporate income taxes as long as they pay out almost all of their profits to investors. Since the distributions are only taxed once (at your individual rate), the result can be higher after-tax returns when compared to corporate dividends that get taxed twice (corporate and individual rates).
Master limited partnerships (MLPs) are mixtures of prior limited partnerships. They provide the tax benefits of limited partnerships and some additional tax breaks as well. As much as much as 95% of the cash they pay out is treated as a tax-free return of capital, so you don't pay any tax until you sell your shares. And when you do sell, some of the earnings will be taxed at the lower capital gains rate. So having the dividends classified by IRS as return-of-capital has the dual benefit of deferring tax and reducing (to a degree) the tax rate.
This tax-deferral feature may also be beneficial to investors seeking an estate-planning vehicle since your heirs will receive the asset based on the current market value, not your cost basis. Thus when they sell it, they will only pay tax on the difference between the sale price and the market value on the day you died.
And unlike limited partnerships, most MLPs are traded on public stock exchanges so they can be easily bought and sold. Just like shares of any stock, they are liquid by simply placing an order at any securities firm. (Note that limited partnerships may have conflicts of interest, high fees and lack of diversification that the investor should review before investing).
If you would like to learn how MLPs might be a viable alternative to those dropping corporate dividends that get whacked twice by income taxes, return the enclosed coupon.
Like stocks and bonds, limited partnership investments involve risks, including the possible loss of principal invested.