Staying a Step Ahead of the Tax Code

05/10/2013 8:30 am EST

Focus: STRATEGIES

Neil George

Editor-in-Chief, Income Publication and Products, Agora Financial

These three companies look attractive because they are adapting to increasing and more onerous tax laws, says Neil George.

The tax code, the tax code, the tax code. It’s going to go on again in 2013. What are they doing, and what are the investment implications?

Well, as we all know, unfortunately at the start of the year you’re starting off with some new tax rates on ordinary income and capital gains. Therefore, as part of the resolution of the several fiscal cliffs that we’re going to be going through this year, all of us as individual investors are starting to see an additional tax bill cutting into our investment returns.

Additionally, we also have the Obamacare surtax on investment income; an added 3.8%. Therefore, looking at that plus some further uncertainty of what might be coming down as we see some further negotiations and maybe some further tax changes on the corporate side and elsewhere, right now the uncertainty as well as the reality of the increased taxes are starting to provide some opportunity for companies to rethink how they’re incorporated.

That’s very interesting. Give us some areas and some names in that field.

I think the key thing, Charles, to think about, is there are two different types of traditional companies. One is a common stock company, pays corporate taxes and then what’s left they pay a smaller dividend to the individual investor.

The other way of looking at it is a passthrough, like a master limited partnership, a real estate investment trust, or an LLC. These are set up so they don’t pay corporate taxes, but have to pay out the majority of the cash flow to the investors. You get a bigger dividend and you don’t have the double tax bill.

This is gaining attention now by more companies that weren’t already REITs and MLPs. We’ve seen CBS Corporation (CBS), the broadcaster that also has a billboard division—those roadside signs, they’re going to spin that off. It’s going to represent about a $6 billion asset base, and the cash flows from that are going to be exempt from corporate tax, and are going to have a fairly significant dividend as those come to the marketplace.

We’re also seeing Cincinnati Bell (CBB) doing a spin out of one of their technology and switching divisions into a potential REIT structure. Again, they'll be able to eliminate and avoid some of the tax implications.

An interesting story that’s come out recently is Waste Management (WM), which hauls the trash from households and businesses around the country.

Yes, what are they doing?

Well, they basically are being asked by some of their significant institutional investors to make a conversion. Management is kind of balking at this at this point, but I think you might be seeing something kind of shaping up.

Waste Management alone I took a look at. They basically spend about a half-billion dollars on federal taxes alone, which would be an immediate cash flow savings to them that can be used for dividends.

How much is that per share?

I don’t have it immediately at hand, but it’s fairly significant. Then if you look at the idea of the actual...if you kept the payout rate as is and you add in that amount of cash flow just from the tax savings and before you actually look at increasing the payout rate, you’d be looking at bringing the dividend up by some 50%.

What’s the downside for management? Why are they balking?

I think the downside to management is that it forces them to actually pay out more cash, and therefore gives them less flexibility.

What I have argued is it actually creates more transparency. The current management has some very healthy pay packages and some other perks that I think might have to be re-examined if they went through a passthrough. So either pay the shareholder or you want to pay management. I’d rather pay shareholders.

The classic conflict. Any other names in this, to take advantage of this?

I think some of the ongoing ones are already in existence. W.P. Carey (WPC) has been a favorite of mine. They’re in the sale of lease back for commercial real estate. They've done very, very well. Again, they avoid the corporate taxes. It does well on the downside.

That explains a lot, because all of the past heredities, such as the real estate investment trusts and the MLPs and even the LLCs and other passthrough entities—and in particularly the private equity field—have really boomed in the last 12 to 24 months, haven’t they?

Everyone has been setting up for the increase in tax rates. We’re probably going to see a change in corporate tax rates as well, making these even more attractive. Even for the existing participants in the market, both public and private, this is a great time to be looking at this facet—particularly for an individual investor, because you’re going to be able to save taxes and increase your dividend yield as well.

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