From Bill Frietsch: “Please discuss pros and cons of Master Limited Partnerships such as Lakehead Pipelines (LHP). This seems like an ideal growth and income stock since it’s return is almost 8% and most of that is not taxable. I realize that taxwise, some of the return is considered a return-of-principal which will up the capital gains when sold, but I intend to hang on to it. It propably won’t be sold until my estate is settled and then my heirs won’t have to pay any capital gains. I also realize that the tax reporting is cumbersome, but it seems like the advantages outweigh this disadvantage. Would appreciate your take on this.”

I don’t know anything about Lakeland Pipelines specifically, but I do think master limited partnerships can be interesting. I’ve done well with them myself.

But let me explain some of the shorthand in Bill’s question.

First off, at least under current law, capital gains are not taxed to your heirs when you die. So while it’s a sort of extreme tax-avoidance measure (“I’d rather die than pay 20% of my Yahoo profits to the government!”), it is something to be aware of if you’re hoping to leave money to your kids. (If you’re planning to leave it to charity, it doesn’t matter.)

But that’s true of anything, not just stocks like LHP. Indeed, stocks like LHP are not, as Bill infers, strictly speaking stocks at all, although quite a handful of them trade on the New York Stock Exchange — they are master limited partnerships, and very much like Real Estate Investment Truss in most respects. Basically, they own oil pipelines or timber (or real estate, in the case of REITs) and they pass through to you, the limited partner, almost all their revenue each year. Some of that revenue is considered “a return of capital,” not profit, and so is not subject to current income tax. Instead, if you paid $2,500 for 100 shares at $25, and get $200 back, half of which the general partner informs you is a “return of capital,” you pay tax on only $100 of that $200 — but are supposed to “lower your tax basis” on the purchase from $2,500 to $2,400 . . . and then more in subsequent years as you get more returns of capital . . . so that when you eventually do sell your shares, if you do, you figure the gain or loss not on the original $2,500 you paid, but on your adjusted “basis” at the time of sale. I.e., the gain you pay tax on gets bigger as your basis shrinks.

In theory, this is swell. In the first place, you defer the tax on that $100 (or eliminate it altogether, unless they change the tax law, if you die before you sell it). In the second, you convert what would have been taxed as ordinary income into an ordinarily-more-lightly-taxed capital gain.

In theory. In fact, if you actually did all the accounting for that $100 properly — well, it’s really not worth it. (If you’re buying $2.5 million of this thing, not $2,500, then maybe it’s worth it.) Indeed, I put most of my shares of this kind in my tax-deferred retirement account, to avoid the hassle. And when I’ve owned them outright, I’ve sometimes just ignored the tax advantage and treated the entire dividend as a dividend, rather than deferring the portion that is, technically, a “return of capital.” I don’t know if this is legal, but as it results in a higher, not lower, tax bill, I can’t imagine the IRS will come after me demanding I accept a refund.

(There’s one other nasty tax twist — see below.)

Maybe it’s time I explained what a “return of capital is?”

Nothing’s quite this simple in reality, but say you started a company that did nothing but buy 1000 acres of land at $1,000 an acre that you operated as a camp ground. You had shareholders. And every year, you’d pay out dividends from the profits you made letting folks come pitch their tents and buy bottled water from your little store. (And bug spray! This is your ace in the hole.) But then one year you actually sold 50 acres to some nut who was willing to pay $3,000 an acre to pitch his tent permanently. That’s $150,000, and you distribute it along with the bug spray profits to your partners. But is it all profit? No, $50,000 of it is merely a return of your original capital — the $1,000 an acre you paid for the land.

It gets a lot more complicated with depreciation and depletion and one thing and another I don’t pretend to understand, but as a shareholder in a master limited partnership (MLP) or real estate investment trust (REIT), you will be sent all the information you need to give your accountant to do your taxes.

(The final tax twist, or should I say nightmare, is that even within a tax-deferred retirement plan, certain kinds of income above $1,000, EVEN THOUGH RECEIVED WITHIN THE UMBRELLA OF YOUR IRA OR WHATEVER, are taxable. This is nuts and should be changed, but — and I did not even know about this until after writing this column originally — there’s no arguing with the tax code. The name of this problem, or at least the way you are supposed to knuckle under to it, is Form 990-T — Exempt Organization Business Income Tax Return. If one of your MLP’s paid you more than $1,000 in “income not substantially related to its business purpose,” then you owe tax on the excess, and the trustee of your retirement plan may notify you, as mine did me.)


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