Unfortunately, for me and I suspect most other investors, the month is marred by one dreaded date–April 15.  Tax day is never a joyful occasion, but it’s sad to think that in a few years we may look back on April 15, 2010, fondly and reminisce about the good old days of low taxes.

I won’t mince words, but please don’t shoot the messenger: US taxes are headed sharply higher in coming years.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) cut marginal income tax rates across the board, setting a top marginal individual income tax rate of 35 percent. EGTRRA also set a maximum tax rate on “qualified” dividends of just 15 percent and lowered capital gains tax rates. 

Unfortunately, EGTRAA also included a sunset provision; on Jan. 1, 2011, US income taxes will revert to pre-EGTRRA levels. Once again, dividends will be taxed at full marginal tax rates, and all income-tax brackets will rise–the top marginal tax rate will revert to 39.6 percent. 

Some commentators argue that US marginal tax rates are ultra-low by any historical standard; even if the top tax rate does revert to 39.6 percent, that’s a far cry from the top rate of 70 percent that prevailed in the 1970s and rates in excess of 90 percent in the 1950s and ‘60s. But that argument doesn’t hold water; you can’t compare tax regimes simply by looking at marginal rates. For example, in 1975 a couple had to earn over $180,000 per year to qualify for the 70 percent tax bracket; in today’s dollars that’s over $725,000. In addition, the kinds of expenses you could deduct against income differ wildly.

Examining the total taxes as a percent of gross domestic product (GDP) provides a direct measure of how large the tax burden is on the economy.

Source: Congressional Budget Office

This graph tracks US individual income taxes as a percent of GDP and includes the Congressional Budget Office’s (CBO) projections through 2019. The underlying data covers only individual income tax rates–not corporate taxes, state taxes or taxes paid into the Social Security and Medicare systems. In other words, the graph underestimates the total tax burden on the US economy.

It’s clear that by the end of the decade US individual income will rise to at least the levels that prevailed in the 1970s. Although marginal tax rates were higher in the 1970s, the federal government’s take as a percentage of GDP was significantly lower in the 1970’s. That’s a scary statistic.

And there’s more for investors to worry about. House Resolution 4872, more widely known as the Healthcare reform bill, raised more than $400 billion in new taxes over the next decade. The largest source of funds is a 0.9 percent hike to the Medicare tax rate for couples earning over $250,000 per year. Even worse, for the first time in history the Medicare tax will apply to “unearned income”–i.e., dividends and interest income.

As the expiration of EGTRRA approaches, investors need to identify tax-efficient investments. The lower qualified dividend tax rates were a huge boon for income-oriented investors who live off the dividends their portfolios generate. And with America’s aging population, more investors fit into this category than ever before; this group will be looking for alternatives to ensure a comfortable retirement/.

High Yields and Low Taxes

Master limited partnerships (MLP) offer income protection in an era of rising taxes. To qualify for MLP status, a partnership must generate at least 90 percent of its income from what the Internal Revenue Service (IRS) deems “qualifying” sources; these include all manner of activities related to the production, processing or transportation of oil, natural gas and coal.

Most MLPs operate in the midstream energy business–the transportation and storage of oil, refined products and natural gas. MLPs save investors taxes in two key ways: They pay no corporate tax, and the IRS deems much of the distributions paid out as a return of capital–taxes on these monies are deferred until you sell your position.

The reason MLPs do not pay corporate income tax is simple: They aren’t corporations. These companies are simply partnerships that are publicly traded on the New York Stock Exchange or Nasdaq just like any other stock. As such, MLPs pass through the majority of their income to investors in the form of regular quarterly distributions. Each investor is responsible for paying tax on his or her share of distributions received.

Investors tend to ignore corporate income taxes because they’re not responsible for paying them in the same way as individual income taxes. But make no mistake about it: You still pay corporate income taxes, especially if you’re an income-oriented investor. Because the corporation is responsible for paying these taxes, the firm has less cash available to pay dividends or invest in its growth. And once the corporation pays the dividend, individual investors must pay tax on that same income.

Some commentators argue that US companies don’t pay much in the way of corporate taxes because they have ways of reducing their tax liability. Like individuals, corporations can deduct certain expenses against their income, but that doesn’t mean they don’t pay taxes. In 2009, corporate income taxes stood at about 1 percent of US GDP; by 2012, that figure is expected to double–hardly a trivial sum.

MLPs raise capital by issuing units, the equivalent of common shares. MLP investors are referred to as unitholders. In addition, the regular quarterly cash payments MLPs pay out are known as distributions rather than dividends. Because MLP distributions aren’t dividends, MLP unitholders don’t get a form 1099 at tax time. Instead, unitholders receive a K-1 form–a standard partnership form that’s typically mailed to unitholders in March.

As a limited partner in the MLP, the K-1 form you receive details your share of the income, gains and/or losses in the partnership over the course of a year. In addition to income, the K-1 form details various tax protections accruing to the untiholder. Depreciation, a non-cash accounting charge against income is a common tax shield; these charges are often high for MLPs, as they tend to own massive depreciable assets such as pipelines and gas storage facilities.

Because of the depreciation allowance, a large proportion of the distribution you receive from a typical MLP is considered a return of capital by the IRS. Although percentages will vary, roughly 75 to 90 percent of an MLP’s distribution is considered return of capital–the remainder is taxable as ordinary income. You don’t pay taxes immediately on the return of capital portion of the distribution. Instead, return of capital payments serve to reduce your cost basis in the MLP. You’re not taxed on the return of capital until you sell the units.

In other words, 75 to 90 percent of the distribution you receive from the MLP is tax-deferred.

Here’s an example for clarity. Assume you purchased $50 worth of MLP units and receive $5 in annual distribution payments, $4.50 of which is classified as a return of capital. After one year, your cost basis on the MLP would drop to $45.50 ($50 minus $4.50); no income tax is paid on that $4.50. You’d pay normal income tax rates on the remaining 50 cents.

When you finally sell the units or the cost basis drops to zero, a portion of any capital gains are taxed at the special, long-term capital gains tax rate. The remainder is taxed at your full income tax rate. But in most cases, investors should hold MLPs for long periods to reap the full benefit of distributions. This enables you to defer 75 to 90 percent of your taxes for several years or indefinitely–a tremendous benefit for most investors.

Many investors find the term “return of capital” confusing. This is simply a tax term; it doesn’t mean that the partnership is literally giving you back your investment. It is simply a way for MLPs to pass through deductions and tax credits such as depreciation. It is these passed-through tax credits that generate tax-deferred return of capital.

This is also one reason that earnings are next-to-meaningless for MLPs and limited liability companies (LLC), a closely related type of publicly traded partnership (PTP). Standard earnings measures include a large number of non-cash charges–accounting entries that don’t have a real impact on cash the partnership receives in the course of doing business. In fact, most MLPs and LLCs try to maximize these charges to shield your income from taxation.

A more meaningful measure of earnings power for partnerships is distributable cash flow (DCF). To calculate DCF you simple add all non-cash charges back into the earnings figures and then subtract a measure known as maintenance capital. Maintenance capital is a measure of the total cash investment needed each year to maintain an MLP’s assets in good working order. I wrote more extensively about DCF and the irrelevance of earnings for MLPs in the Oct. 28, 2009, issue of The Energy Letter, EPS and MLPs.

I continue to receive plenty of questions from subscribers about new carried interest legislation coming out of Congress. These bills will not affect the way your MLP distributions are taxed, as I explain in the Jan. 2, 2010 issue of PF Weekly, Don’t Get Carried Away.

And MLPs are a lot more than just a tax dodge–these are real companies that own key energy infrastructure. Cash flows from midstream energy assets like pipelines and storage facilities have little relationship to commodity prices or the state of the economy. For example, most interstate pipelines charge a capacity reservation fee that producers pay to ship oil or gas regardless of whether they use the pipeline or not.

Typically, when an MLP is looking to construct a new pipeline, it will obtain long-term contracts from major producers to guarantee cash flows from the asset over time. MLPs lock in customers before they turn the first shovel of dirt on a new project.

Of course, some MLPs have exposure to commodity prices. But this can be an advantage at times; exposure to the energy business can produce dramatic growth in distributions when the market is good.

Distribution growth will be a major upside catalyst for the group this year. Several large MLPs have recently raised capital via the debt and equity markets and are deploying the proceeds to fund acquisitions and/or the construction of new cash-generating assets.   

The word “acquisition” sends chills down the spines of many investors because of high profile deals gone wrong. Examples include Quaker Oat’s acquisition of juice drink maker Snapple in 1994 for $1.7 billion; just three years later, Quaker sold Snapple to Triarc for just $300 million. And what investor can forget the long list of ill-fated technology mergers and acquisitions during the tech boom, a trend that culminated with Time Warner’s (NYSE: TWX) infamous $284 billion purchase of AOL (NYSE: AOL) in 2000.

Bad deals aren’t unheard of in the MLP space, but the risk of an ill-fated tie-up is lower for MLPs than it is for most companies. The market typically vales MLPs based on their ability to pay distributions and grow distributable cash flows; distribution cuts can be disastrous for an MLP’s unit price. The shareholder base seeks steady income from quality assets, not promises of long-term growth and synergies. Accordingly, MLPs typically cannot afford to make deals that would threaten payouts aren’t quickly accretive to distributable cash.

A Tax Day Gift

Explaining the ins and outs of the MLP business and all of our favorite plays in the group would take thousands of additional words. And my publisher is already on my case for writing too much and giving away too many details in free e-mail newsletters such as The Energy Letter. I am sure I’ll be hearing about this 2,500 word issue later today.

To simplify matters and avoid any conflict, Roger Conrad and I have decided to give investors a Tax Day gift in the form of a free 30-day trial to our dedicated service covering the MLP industry, MLP Profits. In the service, we have three model portfolios, ranging in risk level from Aggressive Growth to a safety-first Conservative Portfolio. The average yield on our Aggressive Growth Portfolio is roughly 9.25 percent, while the average Conservative holding offers a still-respectable 6.4 percent. And on top of that yield, we’re looking for some of our favorites to boost their payouts by as much as 10 to 15 percent in 2010.

If you’re interested in learning more about MLPs, you can take advantage of our free 30-day trial by clicking here.