While common stock is far and away the most common type of equity that investors will ever own, it's not the only animal in the Wall Street zoo. Particularly for those investors who desire an income stream, there are several different types of equities to choose from -- each with its own operational and tax characteristics.
Common stock is pretty straightforward, so I won't belabor the subject. Corporations like General Electric (NYSE: GE ) and Wal-Mart (NYSE: WMT ) pay taxes on their income and can elect to distribute some portion of the remainder to shareholders. Under present legislation, investors can receive more advantageous tax treatment of dividends that meet the "qualified dividends" standard.
Preferred stock is a different animal -- often behaving like a hybrid between stock and bond. Though preferred stock generally has priority claim on income for dividends, these rights are often subordinate to debt obligations.
REITs (real estate investment trusts) are another common and popular option for investors desiring income. REITs are different from regular corporations. They generally obtain their income from operating or financing real estate, are required to distribute at least 90% of taxable income to investors, and are allowed to deduct paid dividends from taxable income. Consequently, most REITs try to pay out about 100% of their taxable income as dividends.
But the treatment of those dividends is different. Because REITs do not pay tax on that distributed income, REIT dividends are not generally "qualified dividends" and are often taxed as ordinary income. The situation is complicated, though, by the fact that many REITs also make capital gains distributions and/or returns of capital -- forms of distributions that are subject to lower capital-gains tax rates.
Finally, we have partnerships. Also called limited partnerships (LPs) or master limited partnerships, these arrangements are "pass-through" entities. That means there is no singular entity that pays taxes on the partnership's earnings. Rather, the income from the partnership is passed through to the partners and taxed on an individual basis.
Only certain types of businesses are allowed to be organized this way. Generally speaking, a publicly traded partnership must derive 90% or more of its income from interest, dividends, real estate, commodities, minerals, or other natural resources like timber. For examples, investors can look at the likes of Penn Virginia (NYSE: PVR ) , Plains All American (NYSE: PAA ) , or Enterprise Products (NYSE: EPD ) .
Partnership distributions get a very different tax treatment. Distributions are treated as a return of capital, and they reduce the partner's cost basis. When the partnership units (shares) are sold, the investor computes a taxable gain based upon the difference between the sales price and the adjusted cost basis (assuming that it's positive). Some of this gain is treated as capital gains, and some is treated as ordinary income -- but not until the units are actually sold.
Given the potential complexities of these tax matters, investors should consider seeking out professional tax advice with respect to their individual tax situations and potential partnership investments.
Investors considering partnerships must also remember that they are not given the same legal shielding as corporations. While limited partners (those who buy publicly traded partnerships are limited partners) do enjoy limits on their liability, creditors can seek the return of capital distributed to partners if the liability predated the distribution. Also, tax liabilities can result from audits conducted long after they sell their units. That said, both of these events are relatively rare.
Income investing is a great way to build wealth through the stock market -- whether as a core strategy or as a supplement to more capital gains-oriented investments. Although REITs and partnerships are birds of a different feather, they can produce considerable cash flow for investors and are certainly worthy of consideration.
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Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).