Is it possible to earn passive income today and defer the taxes on the income for years? Yes, read on to find out.
You may be thinking that I am referring to tax free municipal bonds, but these investments don’t give you tax deferral they eliminate taxes.
There is a class of investments called Master Limited Partnerships (MLP) that are partnerships that trade like stocks. When you buy into these investments you are not a stock holder but a unit holder, a partner. This distinction comes with addition issues that you should know about before you buy. Don’t worry too much, for most people these investments won’t be more trouble than regular stocks if you follow some guidelines.
First, Investment Quality
By design in law, MLPs are limited to specific businesses, including primarily energy extraction, storage and transportation (there are a few financial companies such as REITs and investment manager companies that also have this structure). These investments are not well known due to a lack of Wall Street interest and low institutional ownership.
Even without the special advantages that they offer due to their structure, high quality partnerships offer stable and predictable returns, while also offering growth potential in earnings and distributions. This article on SeekingAlpha talks more about MLPs and how they earn their income.
Under a normal corporate structure, the company pays corporate taxes (up to 35%) on its earnings. Then, if dividends are distributed to shareholders, they are responsible for paying taxes at a lower rate (up to 15%). Even though the shareholder gets a break on the dividend tax the income is still taxed twice.
Under the MLP structure, the company does not pay corporate taxes, the taxes are the responsibility of the unit holder when distributions are made. So, the double taxation problem is eliminated. Also, most of the income distributed (perhaps 80% or more) is considered a return of capital (ROC). The tax on the ROC is deferred until you sell the units. For a more detailed explanation and example, read the following Investopedia article.
By owning these investments, you can earn 8-10% per year (or more) in stable income and defer the income tax on 80% or more of the income.
- The primary reason why these investments are complicated to handle at tax time is that you need to keep track of all the money you get in income over the years and account for it when you sell the security.
- MLPs may distribute some cash that is considered ‘unrelated’ to its primary tax exempt status. If you own an MLP in a tax deferred account (IRA), there may be tax due on this unrelated income (UBTI) in the same year. Solution: Don’t own an MLP in your IRA. Even if you do, most likely tax wouldn’t be due unless you have a very large position.
- As the Investopedia article talks about, the income tax on ROC can be due before you sell if the money you get in distributions exceeds the cost of the unit. If hold these units long enough you will earn more in distributions than you paid.
- An Investopedia article talks about MLP structure and tax advantages.
- Read this SeekingAlpha article that talks about MLPs.