No one likes paying taxes -- but a certain type of company has managed to stiff the taxman.

Master Limited Partnerships (MLPs) have a powerful tax advantage that most investors don't understand. If used properly, investors can generate large amounts of income while deferring taxes, as long as the investor doesn't sell the MLP. Read along, and I'll explain how you can use this advantage to reap income.

The secret of MLPs
An MLP is a legal structure that generally owns pipelines, resources, refineries, terminals, or other large assets related to natural resources, commodities, or real estate. Profit flows straight through the business untaxed, and gets paid to shareholders -- here known as unitholders -- as distributions from the business's cash flow. Unitholders are then responsible for paying their share of the partnership's taxes (even if the MLP is held in an IRA, which is not recommended). However, unitholders are taxed only on their share of the MLP's income, which is usually a much lower number than the amount of cash the business is bringing in.

Since an MLP's assets are generally very expensive, MLPs tend to have high depreciation (a non-cash charge to account for decline in an asset's value) for years. This charge lowers the MLP's net income, yet has no effect on the cash the business generates. For investors, this means you get cash now, but pay very little in taxes.

Let's see what this looks like:

Company

TTM Yield

Distributions per share

Income Per share

Taxes per share*

Kinder Morgan Energy Partners (NYSE: KMP) 6.1% $4.40 $1.41 $0.49
Cheniere Energy Partners LP (AMEX: CQP) 9.3% $1.70 $0.65 $0.23
Inergy LP (NYSE: NRGY) 7.1% $2.37 $1.71 $0.60
Buckeye Partners LP (NYSE: BPL) 6.4% $3.88 $1.66 $0.58
Linn Energy LP (Nasdaq: LINE) 6.8% $2.58 ($0.81) N/A
Penn Virginia Resource Partners LP (NYSE: PVR) 6.9% $1.56 $0.95 $0.33
AmeriGas Partners LP (NYSE: APU) 6.1% $2.82 $2.72 $0.95

Source: Capital IQ, a division of Standard & Poor's. 
*Assuming 35% rate.

Assuming an income tax rate of 35%, an investor in Kinder Morgan Energy Partners last year would have received $4.40 per share while only paying $0.49 in taxes.

The taxman cometh
Nevertheless, the IRS is not a charity, and at some point you will have to make them whole. This happens when you sell the MLP. Normally, you have to pay capital gains on the difference between what you paid for a stock, called your cost basis, and what you sold it for. However, this process gets slightly more complicated with an MLP. (Don't worry too much: An MLP will send you a K-1 tax form every year laying out your taxes owed. Most tax software makes it easy to handle the form.)

First, every time you receive a distribution from an MLP, the IRS treats part of that distribution as a return of capital, thus lowering your cost basis by that amount. Second, the taxable MLP income is added to your cost basis, raising it by that amount. When you sell the MLP, you owe capital gains taxes on the difference between what you bought and sold the MLP for, like normal. You also owe income taxes on the difference between the adjusted cost basis and the price at which you purchased the MLP. Hypothetically, it would look like this, assuming income of $1 a year and distributions of $5 a year:

Cash Flows

Year 0

Year 1

Year 2

Year 3

MLP Purchase

$50.00

     

MLP Cost Basis

$50.00

$46.00

$42.00

$38.00

Income Tax From MLP Income ($1 x 35%)

 

($0.35)

($0.35)

($0.35)

Distributions

 

$5.00

$5.00

$5.00

MLP Sale

 

-

-

$60.00

Capital Gains Tax on Sale ($10 x 15%)

 

-

-

($1.50)

Income Tax on Sale ($12 x 35%)

 

-

-

($4.20)

Total Cash Flow

($50.00)

$4.65

$4.65

$58.95

As you can see, an MLP just defers taxes -- it doesn't cancel them. The advantage falls to the long-term investor who can defer taxes for decades, compounding the rewards of a seriously high dividend. One caveat, though: If your cost basis falls to zero, distributions are then immediately taxable. The government does not allow negative cost basis.

If your head is spinning from all these complexities, and you want huge dividends without quite so much hassle, consider the 13 names in a free report from The Motley Fool's expert analysts, 13 High-Yielding Stocks to Buy Today. A senior retail analyst dubbed one of the picks as "the dividend play of a lifetime." Hundreds of thousands have requested access to this report, and today I invite you to download it at no cost to you. To get instant access to the names of these 13 high-yielders, simply click here -- it's free.

Dan Dzombak can be found on his Twitter account: @DanDzombak. He does not own shares of any of the companies mentioned in this article.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.