Two Ways to Master Income and Taxes

11/07/2007 12:00 am EST

Focus:

Richard Band

Editor, Profitable Investing

Richard Band, editor of Richard Band’s Profitable Investing, finds two master limited partnerships that pay great dividends and limit tax exposure.

Right now, master limited partnerships (MLPs) are my favorite energy-income vehicle, hands down.

Like real estate trusts, MLPs themselves pay little or no federal income tax. Result: they can pass along a much higher cash yield to you, the investor, than an ordinary corporation can.

What’s more, thanks to depreciation deductions, the lion’s share of most MLPs’ cash payout escapes tax until you sell your units. If you keep your units as long as you live, your heirs will never owe income tax on the amount you deferred—a splendid estate-planning angle.

Yes, MLPs do add to your paperwork at tax-filing time. Also, because of a quirk in the law, you shouldn’t stash MLPs inside your tax-sheltered retirement account. Finally, it’s worth remembering that Congress could change the tax laws to limit, or even curtail, the benefits of MLPs.

Assuming you can handle these contingencies, my top pick in the MLP space is Energy Transfer Partners (NYSE: ETP), which operates a 14,600-mile pipeline system, as well as a major propane-distribution business. The partnership is a bargain, yielding 6.1%. In late September, ETP raised its distribution for the 15th quarter in a row. In just three years, the payout has doubled.

How could [such] an investment still be so cheap? In July, the Federal Energy Regulatory Commission issued an order against ETP, seeking $167 million in penalties and damages because, FERC alleges, the partnership undercharged customers for natural gas during the market chaos triggered by Hurricane Katrina in 2005.

Any sensible federal judge would throw out such a frivolous case, but I can’t imagine that FERC will get more than a small percentage of the money it’s asking for.

ETP insiders certainly don’t think so. They’ve lapped up a stunning $3.5 million worth of partnership units since the FERC news broke. Buy ETP at $54 or less. (It closed Tuesday below $53.) I’m projecting a total return of 20% or more in the year ahead.

If you’re leery of the tax complications, Fiduciary/Claymore MLP Opportunity Fund (NYSE: FMO) is a closed-end fund that specializes in MLPs. By investing in a fund, you not only diversify your MLP holdings but you also drastically simplify your tax reporting.

FMO issues a plain-vanilla Form 1099 at the end of the year, [and] you’ll never have to file out-of-state tax returns. And the restrictions on holding MLPs inside a retirement account don’t apply.

Last year, FMO’s entire payout—100%—qualified as a tax-free return of capital. A return-of-capital distribution reduces your tax cost (basis) when you go to sell, but until then, the money is all yours.

FMO borrows money to purchase additional partnership units. That introduces an element of volatility in the share price. Over the long run, however, I expect FMO’s leverage to help your results, since the cost of borrowing tends to be lower than an MLP’s total return. Its current yield: 6.2%. (It closed below $24 Tuesday—Editor.)

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