Tim's Corner: A 'Tax Free' High Yield Play

"For every complex problem there is an answer that is clear, simple, and wrong" - H.l. Mencken

This instablog post comes from Tim Plaehn, expert on income investing and a friend & colleague of mine at Investors Alley as well as a contributor here on SeekingAlpha. Tim runs the Dividend Hunter newsletter which offers a solid & diverse selection of attractive high yield plays. The service is now over 5,500 active subscribers and can be had HERE for the rock bottom price of $49 for the first year.

Tim's Corner:

By Tim Plaehn,

Buying this stock will give you a tax-free income stream of 8% a year without any of the headaches of filling out a K-1 tax form. Not only will you be rolling in high-yield income, but you can sleep sound at night knowing that this is coming from a business with stable, long-term revenues backed up by an investment grade credit rating. This is one of those rare stocks that you can buy and hold forever.

Since each investor has a unique tax situation, I generally do not include tax considerations when I recommend a high-yield stock. However, when the opportunity arises to earn a currently tax-free 8% yield from a company with an investment grade credit rating, I am certain there are investors that would benefit from that level of tax-advantaged income.

The master limited partnership –MLP—business structure operates as a partnership for tax reporting purposes. An investor who buys units of a publicly traded MLP becomes a limited partner. As partners, investors receive an IRS Schedule K-1 each year, which lists their share of the MLPs profits or losses for the year. The K-1’s are used when filing individual income tax returns. The distributions paid on MLP units are not part of the profits or losses. Those distributions are classified return of capital for tax purposes and are not considered to be taxable income. This means that MLPs pay tax advantaged income, but the trade-off is more complicated tax filing.

In 2016, pipeline MLP, Plains All American Pipeline, LP (NYSE: PAA) initiated a simplification of its business organization. Prior to second half of the year, Plains had a separate general partner and paid incentive distribution rights –IDRs– to the GP. A separate publicly traded company, Plains GP Holdings LP (NYSE: PAGP) owned a portion of the PAA IDRs. MLP incentive distribution rights payments are an extra capital cost for a public MLP.

The simplification plan eliminated the IDR payments. In exchange for giving up the IDRs, PAGP received PAA LP units. Now each PAGP share is backed by one PAA LP MLP unit. Now, from an investment standpoint PAA units and PAGP shares are the same, with the same dividend rates and backed by the same assets. The difference is that PAGP, while organized as a partnership, has elected to pay taxes as a corporation. This means that PAGP investors receive a simple Form 1099 instead of the more complicated K-1.

The distributions paid on the owned PAA shares to PAGP are passed straight through as dividends to investors. The PAGP dividends retain the return of capital classification. It is possible that at some point in the future, PAGP could become liable for corporate income taxes, and at that point a portion of the dividends could become taxable income.

At this point in time the PAGP dividends are non-taxable income. That’s a pretty good deal. Return of capital dividends are not completely tax free. They reduce your cost basis in the shares, and if you sell the shares, you would recapture the dividends as taxable income in the form of a capital gain that is the difference between the selling share price and the cost basis.

Plains All American Pipeline primarily owns crude oil pipelines and storage assets. The company has the largest independent crude oil storage and transport network in the U.S. The inter-connected nature of the network often lets Plains earn several fees on a single barrel of oil as it makes its way from the wellhead, through pipelines and storage to end up at a refinery or export location.

PAA is one of the largest MLPs. It is the third largest by market cap. The company is also one of the handful of MLPs with an investment grade credit rating. The current distribution rate is sustainable, with potential for dividend growth in the future. PAGP currently yields 8.3%.

PAGP offers the unique combination of a secure, tax-advantage high yield, without the tax complications of a Schedule K-1. With the recent drop in crude oil, the shares are oversold and now is a great time to pick up shares and lock in that 8% plus yield.

"A cynic is a man who, when he smells flowers, looks around for a coffin" - H.L. Mencken

Thank You and Happy Hunting

Bret Jensen

Founder, Biotech Forum & Insiders Forum