Pass-Through Profits

11/21/2013 9:00 am EST

Focus: STRATEGIES

Robert Hsu

Editor, China Strategy and Asia Edge

My favorite kind of money comes directly to me, and it doesn't make any stops along the way, either. That's why I like master limited partnerships, REITs, business development corporations, and private equity firms, explains Robert Hsu in Money Morning.

You see, all of these companies are organized as pass-through entities. They're set up differently than traditional public corporations.

While traditional corporate structures are designed to retain earnings, pass-through entities, such as these, are designed to funnel as much as 90% of their earnings directly to shareholders.

And you'll get to keep far more of your pass-through profits, too. For shareholders, pass-through securities offer the limited liability protection of traditional corporations, but without the infamous double tax bite you'd normally take from Uncle Sam.

Because pass-through securities' cash flow is paid out to shareholders—without corporate tax—and is only taxed once at the partner level. This makes many of their annual dividend yields much more attractive.

Because these companies are obligated to distribute some 90% of their earnings to unitholders, there is little in the way of retained earnings left; this forces MLPs to be lean and efficient.

Because of lower taxes, cash-producing assets, such as oil wells, become more profitable under MLP ownership than corporate ownership.

Many MLPs take advantage of their favorable tax structure by buying oil wells from energy companies barely making money on these wells after tax.

For example, while most energy stocks offer yields of about 3%, most of the biggest energy MLPs offer yields in the 8% to 10% range.

This kind of yield is something that's attractive to most investors, especially those who are focused on generating income from their existing assets.

I remember the 1980s, when Congress first approved the use of MLP structure in energy exploration and production firms. I knew then, as now, that this unique approach had a bright (and profitable) future ahead of it.

It wasn't long after approval that other companies in other industries made the move to become pass-through entities.

The tax advantages alone made sure that happened. And three decades later, we have much more to choose from: MLPs, REITs, BDCs, and private equities.

They're different securities, of course, but they're all my favorite kind of money. The shares below all represent MLPs, REITS, and BDCs. There are plenty of great investments in this group, but these are my very favorites:

  • Vornado Realty Trust (VNO)

  • Teekay LNG Partners L.P. (TGP)

  • Kinder Morgan Energy Partners L.P. (KMP)

  • The Blackstone Group L.P. (BX)

  • Kohlberg Kravis Roberts & Co. L.P. (KKR)

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