These days, the only thing better than getting solid income from your stocks is getting solid, tax-advantaged income from your stocks. Thanks to a recent ruling from the IRS, a number of companies may be able to take advantage of a favorable tax status once reserved solely for energy and natural resources businesses.
Later in this article, I'll get into the technical nature of the IRS decision and what it means for investors. First, though, let's take a look at the type of investment at issue: the master limited partnership.
Master of their domain
In their search for greater income, investors have discovered a number of previously obscure types of assets that emphasize distributions to shareholders. Mortgage REITs and business development companies, for instance, offer impressive yields that in many cases top the 10% mark, due to the requirement that they pay out the bulk of their net income in distributions to investors.
But in many ways, master limited partnerships give investors an even better deal. Because of their status as partnerships, MLPs tend to make big distributions to their unitholders. Yet because of the nature of the business in which most MLPs operate, a good portion of those distributions qualify as tax-free return of capital rather than ordinary income. That doesn't mean that investors avoid tax forever, as the IRS usually recaptures the return-of-capital tax break when investors sell their MLP units. During the interim, however, investors enjoy deferral on their distributions.
Even better, MLPs avoid corporate-level income tax. That leaves these companies with more income to distribute back to their unitholders.
Opening the doors
In order to qualify as a master limited partnership, a business has to fall into certain IRS-approved categories. The section of the tax law dealing with MLPs describes businesses whose "income and gains [are] derived from the exploration, development, mining or production, processing, refining, transportation ... or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber)."
That definition clearly allows fertilizer maker Terra Nitrogen (NYSE: TNH) to qualify as an MLP. But for the most part, MLPs tend to be pipeline or other midstream energy companies.
Last week, though, the IRS ruled that a certain type of business known as "steam cracking" could qualify for MLP status. Because the process involves taking natural gas liquids and refining them into specialty chemicals known as olefins, the IRS found that the income from such businesses could count as MLP income if the business were properly structured.
The IRS decision is good news for two groups of companies. As a Barron's blog post discussed on Friday, the move appears to validate the decision by Williams (NYSE:WMB) to move an olefin processing facility into its affiliated MLP, Williams Partners.
More important, though, the decision could allow a set of chemical companies to create brand-new MLPs. Last Tuesday, shares of Dow Chemical (NYSE:DOW), Huntsman (NYSE:HUN), and LyondellBasell (NYSE:LYB) all rose sharply along with many of their peers, with gains especially concentrated on those companies that would be best suited to spin off existing facilities into an MLP structure.
Investors could benefit in two separate ways from such a move. In addition to the tax benefits described above, analysts point to the fact that MLPs have tended to trade at higher multiples to operating income than what chemical companies typically fetch. If companies spin off MLPs and their share prices rise, then shareholders who hang on to spun-off shares will reap big rewards.
Keep your eyes on the IRS
With the U.S. government still hurtling toward the fiscal cliff with no relief in sight, it's nice to see the IRS giving investors some good news for a change. The thing that all investors need to remember is that even if taxes aren't usually the only reason to make an investment, changes that give investors new benefits can often be significant enough to move a stock. It's essential to watch and see when big tax changes happen.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.