Yes… This is Legal

This article is published with permission from InvestmentU.com.

You worked hard for your money. That means you should do everything within the law that allows you to keep more of it. Last week, Alexander Green showed us why you must find ways to (legally) be a tax dodger. It was great advice.

Now I’m going to show you a tax-dodging solution that’s ideal for income-seeking investors — Master Limited Partnerships (MLPs).

Tax-free income?

MLPs offer investors tax-deferred dividends that are generally larger than anything you’ll find in the realm of blue chips.

Here’s how it works…

An MLP must pay out 90% of its earnings in the form of dividends. As a result, it does not pay corporate taxes (it’s a similar structure to REITs).

An MLP investor is technically a partner in the company, not simply a shareholder. That fact changes the way Uncle Sam treats the dividends.

When an MLP dividend is paid, it is considered a distribution or return of capital. As far as the IRS is concerned, investors are simply getting some of their own money back.

That’s key because we don’t pay taxes on a return of capital. Instead, the payout lowers our cost basis.

Here’s an example.

Let’s say you buy 100 shares of an MLP at $20. The stock pays a 5% yield or $1 per year. After one year, you will have collected $100 and your cost basis has fallen by $1 to $19 per share.

After five years, you’ve collected $500 and your cost basis is now $15. If you sell the stock for $25, you’ll report a $10 per share capital gain ($25 to $15). You’ll have to pay taxes on the capital gain, but you won’t have paid any taxes on the dividend income while you held the stock. (One caveat is if your cost basis goes to zero, the dividend becomes taxable.)

If you were to hold the stock until you die (collecting a lot of income along the way) and leave it to your heirs, their cost basis resets to the current price. If that’s the case, there’s a chance taxes may never be paid on the investment.

IRA… No way

I’m a big proponent of Individual Retirement Accounts (IRAs) as they also help you trim your tax bill. But you shouldn’t put MLPs in an IRA for two important reasons:

1. An MLP is already a tax-deferred asset, so an MLP may be taking up space in the IRA from another investment that would benefit from the tax-deferred status. But more importantly…

2. If you have MLP distribution income over $1,000, you may have to pay Unrelated Business Income tax. And to make it worse, it may be charged at your income tax rate, not the lower dividend tax rate.

For these two reasons, you’re almost always better off keeping an MLP in your taxable accounts.

There is one other thing you should know about MLPs. Instead of receiving a standard 1099-DIV, you’ll get a K-1 form. These forms can be a little more complicated. Some tax software programs don’t handle them well, and your accountant may charge you more if she has to include K-1s.

Speak to your tax professional about whether a K-1 will make your tax return more expensive and if it’s a suitable investment for you.

For many people it is.

It is extremely attractive to score big, tax-deferred yields like the 7.2% from Enbridge Energy Partners (NYSE: EEP) or 7.1% from Energy Transfer Partners (NYSE: ETP) (see my write-up of Energy Transfer Partners here).

Do your MLP homework and you’ll likely find they are a great way to achieve a high yield without having to share your wealth with Uncle Sam.

Marc Lichtenfeld is a senior analyst at Investment U. See more articles by Marc here.