With some of the biggest dividends of the stock market, partnerships are tempting; but you have to know how to get paid without getting burned.
Partnerships are all about paying stockholders to own them. The whole structure of a partnership is set up to pass profits directly to the owners without imposing corporate income tax costs on top of income taxes paid by investors on dividend income.
Partnerships come in a variety of structures that include limited partnerships (LPs), master limited partnerships (MLPs), general partnerships (GPs, which are the managers of MLPs and LPs) and limited liability companies (LLCs). For my purposes, I refer to all of them as publicly traded partnerships (PTPs) or just “partnerships.”
Partnerships have been around in various forms for many years and exist not just in the U.S. market, but in an increasing number of other nations and tax jurisdictions. But the United States has been the biggest market for these companies, thanks to a massive tax reformation that took place in 1986.
Prior to 1986, partnerships were operating wildly in the United States, thanks to income tax rates for individuals that topped 70 percent and a loophole in the U.S. tax code that allowed partnerships to generate losses that could be used to offset passive income (dividends) and active income (salary and bonuses).
Tax reform legislation and subsequent updates changed and reformed the code for partnerships and all other pass-through investments, including real estate investment trusts (REITs), in which losses could be used only to offset passive investment income.
The result was carnage for many investors who were gaming the system prior to the tax reforms. On top of that, the petroleum industry, which has always been a major part of the partnership market, had its own trials, which further soured investors who weren’t prepared for the changes.
A Real Partnership
Partnerships have continued to mature and expand, resulting in a great opportunity in our current market for investors seeking high dividends from solid, cash-generating assets.
A variety of industries fit the bill for partnerships: those that focus on energy production, processing and distribution; and major capital asset businesses, including infrastructure, transportation and other operations.
Energy continues to be one of the biggest parts of the U.S. partnership market. Be careful not to be too invested in energy. A fall in the market prices of crude oil, natural gas, coal and other commodities can have dire consequences for cash flows, dividends and stock prices of partnerships.
Too many investors have been devastated when partnerships that tempted them with super-high dividends succumbed to market woes, resulting in the suspension or elimination of dividends or, even worse, bankruptcy.
Partnerships are just like any other stock that pays you to own it. Every partnership has to prove how it’s going to continue to be profitable with market downturns. It further has to prove how it will be able to continue to finance its debt, both current and pending any maturity or rollover.
Taxes Get Paid One Way Or Another
Before I get to my favored partnerships, I need to go through how the taxes work on partnerships.
As noted above, partnerships are structured as pass-through investments, meaning that profits are earned by the partnerships and then passed through and paid to the shareholders without getting first taxed by the Federal and State governments.
This avoids the dreaded double taxation challenge that impacts dividends paid by ordinary common stocks, and it comes with some additional benefits as well as some pitfalls.
To start, let’s look at the benefits:
- The partnership pays the taxes before you get your cut.
- The partnership is able to pass though depreciation and other costs, listing them as return of capital (ROC). Since most of the dividends the partnership pays out are deemed ROC and not actual earned income, investors aren’t liable for income taxes on much — or in some cases nearly all or all — of the dividend income paid.
While not treated as current income, the ROC must be used to reduce your cost basis for your investment in the partnership. When you sell, you’ll pay on your capital gains; but you won’t have to pay until you sell. At worst, you’ll defer your tax bills; and you might pay at a lower tax rate for the gains. If you die before selling, the shares’ cost basis is reset to the current market.
One more limitation concerns qualified retirement accounts that hold partnerships. Individual retirement accounts, simplified employee pension plans and other plans can hold partnerships, but they are not the most tax-efficient accounts for getting the full tax benefits of the partnership structure.
And if you own too many partnerships inside a qualified account, you could owe taxes as unrelated business taxable income (UBTI). Somebody will eventually have to pay taxes on income — even income generated by partnerships.
Since most income paid by a partnership is ROC, UBTI won’t kick in for the vast majority of the dividend income paid by partnerships.
Another way around this would be to purchase a mutual fund that invests and holds partnerships. In this way, the dividends and gains are treated as any other investment asset. UBTI rules won’t kick in for your IRA or other qualified retirement account that owns such a fund.
Pick A Partner
Now that you know the structure, the industries and the taxes of partnerships, I’ll show you some partners that make my cut.
As noted above, it isn’t just about picking the biggest yielder; it’s about picking a high-paying partnership that has solid assets and debt-paying capabilities and that can sustain industry and credit upheavals.
On the revenue front, I look at the industry, the underlying productive assets and, more importantly, the margins. In the energy markets, prices can fall perhaps even quite dramatically before profits will be squeezed or eliminated. Rising sales with high and rising margins help a partnership make the cut.
More important is the debt side of a partnership. First, I need a partnership to have plenty of cash on hand to pay bills and a low debt-to-assets rate. The combination will make it easy to service existing credit lines and bonds while preparing it to roll over credit lines and maturing debts.
For a few good examples of profitable partnerships, I’m focusing on three of the popular partnership market segments: real estate, petroleum production and pipeline businesses.
To start, look at W.P. Carey, Inc. (WPC).
W.P. Carey focuses on real estate financing, particularly using sale and leaseback structures. Major corporations in the United States and around the world that have assets such as offices, distribution centers or other major properties on their balance sheets liquefy those assets by selling them to W.P. Carey and then turning around and leasing them back for the long term.
Challenging economic times benefit W.P. Carey, since the firm gets to buy assets and lock in leases. That makes W.P. Carey much more valuable and defensible for years to come. The dividend is running currently around 4.5 percent and is well-defended, with profit margins running in the 16 percent range.
W.P. Carey’s debt is controlled, with overall debt running at merely 44 percent of overall capital. And while it has limited debt, its next revolving credit line and term loan are due to roll over next year, amounting to $418 million — a mere fraction of its capital base.
Linn Energy, LLC (LINE) is a petroleum producer that continues to exploit proven lower-cost fields in strategic markets around the United States. It has recently gone through some acquisitions, and it increased its capital base by some new shares sold as well as selling a new intermediate bond to a market that was eager to buy.
Cash and short-term asset balances are heavy on the balance sheet, with a current ratio reaching more than 1.3 times. As the debt markets proved, it is a good credit, with the debt-to-assets ratio running at a mere 49 percent. Paying a bigger dividend that is considered tax-shielded ROC and that runs at more than 8 percent makes the partnership one with potential for additional gains.
Over the weekend, Barron’s ran a story with a very negative slant on Linn, accusing the company of being overly aggressive with hedges against falling petroleum prices. In turn, the magazine suggested that the hedges have been working to support the higher dividend.
The company came out and explained that of course the hedges were helping the distributions, as lower petroleum prices (especially for natural gas components) would reduce the profitability of the company without the hedging.
Enterprise Product Partners L.P. (EPD) has sustained the loss of one of its founders, Dan Duncan; yet it continues to operate in the processing and distribution of natural gas in the United States. The partnership has been a successful payer for many years, yet now it is looking a bit more expensive.
Operating margins are a bit lower right now; profits are down because of the lower operating margins and because of the overall market pricing for natural gas products and services. This is putting some pressure on the dividend growth potential, which has traditionally been quite strong and is steadily climbing.
The credit condition of Enterprise is still good, with the debt-to assets ratio running only at a bit more than 42 percent. But cash and near-term assets are a bit low, resulting in a potentially threatening condition if changes in the markets or the business were to occur.
However, with ample and steady cash flow from operations of the pipe and processing businesses, the company continues to expand. No wonder the market has treated the shares well, continuing to drive them ever higher in price.
The result is a return for investors over the past five years of more than 148 percent compared to the Standard & Poor’s 500 index’s price gain alone of only about 12 percent and current dividend yield of not much less than 5 percent.
– Neil George