Before You Dive Into High-Yield MLPs and BDCs

by Marc Bastow | December 4, 2012 11:50 am

With the fiscal cliff looming closer, everyone has an opinion on how to get more yield from stocks if tax rates on dividends increase from the current 15% rate, among other dire consequences.

Of course, the easiest “fix” might be if the companies sitting on all those trillions on their balance sheets adjust their dividends upwards to offset the additional tax burden, but that’s just wishful thinking.

One way to play increased yields is through the “dividends” found in master limited partnerships (MLPs) and business development corporations (BDCs). Both types of entities promise yields and payouts uncompromised by any increase in dividend tax rates because their payouts don’t qualify as ordinary dividends.

Unlike standard corporations, the MLP structure means these companies don’t pay taxes on their corporate profits. Instead, they send “distributions” to their unitholders (generally on a quarterly basis) representing, by code, 90% of earned income. So, MLPs are not subject to double taxation on earnings.

The same applies to BDCs. As long as the BDC meets certain regulatory requirements, it pays little or no corporate income tax, and must distribute at least 90% of taxable income as dividends to investors.

So, in a nutshell: no corporate taxes and distributions mandated by regulations, leading to historically higher yields than traditional dividend stocks.

But before we get overly excited, here’s the bad news: These investments are trickier than you think.

Start with the IRS reporting. Both entities mail out individual K-1 tax forms to unitholders, generally at the end of February or early March. That’s in the best case. Thanks to the complexities of calculating actual taxable income, the K-1 may arrive just late enough to require filing a tax extension.

Even trickier is the actual taxation. A portion of each distribution is tax-deferred because it it may be the result of depreciation or some other expense items. That nontaxable portion must be subtracted from your original purchase price to compute a new cost basis, and when (and if) you sell, any portion of gain resulting from the deduction is taxed as ordinary income.

Sounds a little daunting? It is. So, here’s the best recommendation: Consult a tax attorney or your financial adviser (hopefully a CPA) before you dive in looking just for that juicy yield.

Keeping those caveats in mind, by all means take a look at some long-standing, solid MLPs and BDCs, and consider adding them to your portfolio. Here are some good possibilities:

Oneok Partners (NYSE:OKS[1], yield: 4.69%) is engaged in the processing, storage and distribution of natural gas, a growing and critical component of the U.S. efforts at energy self-sufficiency[2]. The MLP was founded in 1993, and has been pumping out steady quarterly distributions since January 1994. Looking for a bonus reason to get into the stock? How about a nearly 15% return over the past year, and a searing 93% rise over the last five years?

Buckeye Partners (NYSE:BPL[3], yield: 8.40%) is more focused on the petroleum side of energy as owners of pipelines and storage terminals. The company recently purchased a marine terminal facility in New York Harbor from Chevron (NYSE:CVX[4]) to expand its reach and operations. If you’re looking for stability, consider that Buckeye has paid a cash distribution in every quarter since its initial public offering in December 1986. The streak doesn’t show any sign of changing.

Kinder Morgan Energy Partners (NYSE:KMP[5], yield: 6.3%) is a little bit of everything in that it handles both pipeline transportation and energy storage with 29,000 miles of pipeline and 180 terminals. The company ships and stores everything from oil to gas to chemicals, and that diversity keeps its operation humming. KMP’s quarterly distributions started in 1992 and have yet to see any decrease.

In the BDC category, Allied Capital (NYSE:ALD[6], yield: 6%) invests in mostly private middle-market companies that have earnings before interest, taxes, depreciation and amortization (EBITDA) of between $5 million and $150 million. It invests primarily in the debt and equity of 77 such companies in a variety of industries. The Street has taken notice, as the stock has soared 117% in the last five years.

Apollo Global Management (NYSE:APO[7], Yield 2%) is in the bigger leagues despite a lower dividend yield. Apollo raises private equity monies¬†and invests it in capital markets, real estate funds and managed accounts on behalf of pension and endowment funds. It also works with institutions and high-net worth individuals. For its work and expertise, Apollo collects tidy management and advisory fees. It manages over $100 billion in assets around the world from 10 global offices, and with Managing Partner Leon Black, the company is as high-profile as you’ll find in the sector.

So, no matter how you play MLPs and BDCs, make sure you know about the tax and reporting requirements, and no matter what, do your homework on the companies[8], too.  The last thing you need after feeling good about a 5% yield is a tax surprise down the road.

Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing he does not hold a position in any of the aforementioned securities.

Endnotes:
  1. OKS: http://studio-5.financialcontent.com/investplace/quote?Symbol=OKS
  2. U.S. efforts at energy self-sufficiency: http://investorplace.com/hot-topics/energy-independence/
  3. BPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=BPL
  4. CVX: http://studio-5.financialcontent.com/investplace/quote?Symbol=CVX
  5. KMP: http://studio-5.financialcontent.com/investplace/quote?Symbol=KMP
  6. ALD: http://studio-5.financialcontent.com/investplace/quote?Symbol=ALD
  7. APO: http://studio-5.financialcontent.com/investplace/quote?Symbol=APO
  8. do your homework on the companies: http://investorplace.com/2012/12/6-investing-lessons-from-bdcs/

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