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Dividends: Three Special Corporate Forms
Designed for High Yields
by Dave Van Knapp, author of
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
and
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
October, 2007
In your search for solid dividend-paying companies, you will encounter three
special kinds of corporations that turn up again and again. They have chosen to
organize themselves under various federal laws which allow them to trade
corporate taxation for the requirement that they pay out ("distribute") the bulk
of their profits to shareholders. For this reason, these companies appear
frequently in lists of high-yielding dividend-payers. All three special forms of
companies have ticker symbols, and their stocks trade just as other companies
trade.
Here is a primer on these three special corporate forms:
Real Estate Investment Trusts (REITs)
REITs were created by Congress in 1960. They come in two flavors: Most
REITs are essentially landlords, holding properties from office parks to
apartments to shopping malls. A small number of REITs are “mortgage REITs,”
involved in real estate financing.
To qualify as a REIT, a company must distribute at least 90 percent of its
taxable income in the form of dividends. Historically, most of the return from
REITs has come from these dividends, although many have delivered attractive
price returns to boot.
REITs are the only practical way for most individuals to invest in residential and
commercial real estate developments. Real estate is often considered to be a
distinct asset class (beyond the “big three” of stocks, bonds, and cash), so
REITs offer the investor some diversification benefits. Current dividend yields
often are 5 to 8 percent or more, right out of the gate for new buyers.
Note, REIT dividends do not qualify for the 15 percent federal income tax rate
on most dividends. They are taxed as ordinary income. That is because the
earnings were not taxed at the corporation’s level.
Master Limited Partnerships (MLPs)
MLPs are also a special form of structure. In fact, they are not corporations at
all, but partnerships. By law, their activities are limited to operations in real
estate, and the production, processing, and transport of natural resources.
MLPs appear mostly in the oil and gas industry. They provide small investors a
way to participate in partnerships that otherwise would not be possible. Because
the shares trade, beyond the partnership distributions there is also the usual
potential for capital gain or loss.
Every MLP has a general partner which manages and controls the partnership.
Shareholders in MLPs (technically “unit holders”) are limited partners in the
enterprise. They own an interest in the assets of the business, which in turn
entitles them to dividends and other distributions from the business. They also
benefit from depreciation of the assets of the business.
Taxation of MLPs was established in 1987 by Congress. The partnership does
not pay taxes itself, so the distributions sent to unit holders do not qualify for
the federal 15 percent cap on dividend income. However, not all of each
distribution is a “dividend.” Some of it is a return of the original capital invested.
The returned capital, in effect, reduces the cost basis of the investment (as if the
shareholder had spent less per share in the first place). Returned capital is not
taxed in the year it is distributed, but it is effectively taxed when the unit holder
sells the shares. That is because there will appear to be more profit on the sale
of the shares, since the returned capital over the years reduced the cost basis.
So the returned capital is not, as is sometimes stated, non-taxable; rather the
taxation is deferred. When you finally sell those shares, the taxation catches up
to the distributions received over time.
Because of their unique structure and the complex tax situation, MLPs must
mail an IRS Schedule K-1 to each unit holder every year. This reports the unit
holder's share of the partnership’s taxable and non-taxable income, gain, loss,
deduction, and credits. It is really not that difficult to deal with, and any
competent tax preparer is familiar with K-1’s.
Business Development Companies (BDCs)
BDC’s were created by Congress in 1980 to help provide capital to small
businesses. They have been much in the news lately, usually under the term
“private equity,” as there have been dozens of recent deals in which companies
have been “taken private.” That means that public companies—some of them
quite large—have been bought in their entirety by private equity companies with
huge amounts of capital at their disposal.
Many of these private equity deals have been made by companies which are
truly private, but some of the private equity firms have themselves decided to
go public, becoming BDCs. (Never mind that the size and nature of the resulting
entity and its investments may be far outside the original purpose and spirit of
the law.) When a private equity firm is itself public, that means that the
individual investor has a chance to participate in “big deals” that would
otherwise not be possible.
The law requires BDCs to distribute, at least annually, the bulk of their net
investment income and capital gains to shareholders. Thus they often have
attractive dividend yields. As with REITs, these dividends are not subject to the
15% cap on dividend tax rates.
Designed for High Yields
by Dave Van Knapp, author of
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
and
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
October, 2007
In your search for solid dividend-paying companies, you will encounter three
special kinds of corporations that turn up again and again. They have chosen to
organize themselves under various federal laws which allow them to trade
corporate taxation for the requirement that they pay out ("distribute") the bulk
of their profits to shareholders. For this reason, these companies appear
frequently in lists of high-yielding dividend-payers. All three special forms of
companies have ticker symbols, and their stocks trade just as other companies
trade.
Here is a primer on these three special corporate forms:
Real Estate Investment Trusts (REITs)
REITs were created by Congress in 1960. They come in two flavors: Most
REITs are essentially landlords, holding properties from office parks to
apartments to shopping malls. A small number of REITs are “mortgage REITs,”
involved in real estate financing.
To qualify as a REIT, a company must distribute at least 90 percent of its
taxable income in the form of dividends. Historically, most of the return from
REITs has come from these dividends, although many have delivered attractive
price returns to boot.
REITs are the only practical way for most individuals to invest in residential and
commercial real estate developments. Real estate is often considered to be a
distinct asset class (beyond the “big three” of stocks, bonds, and cash), so
REITs offer the investor some diversification benefits. Current dividend yields
often are 5 to 8 percent or more, right out of the gate for new buyers.
Note, REIT dividends do not qualify for the 15 percent federal income tax rate
on most dividends. They are taxed as ordinary income. That is because the
earnings were not taxed at the corporation’s level.
Master Limited Partnerships (MLPs)
MLPs are also a special form of structure. In fact, they are not corporations at
all, but partnerships. By law, their activities are limited to operations in real
estate, and the production, processing, and transport of natural resources.
MLPs appear mostly in the oil and gas industry. They provide small investors a
way to participate in partnerships that otherwise would not be possible. Because
the shares trade, beyond the partnership distributions there is also the usual
potential for capital gain or loss.
Every MLP has a general partner which manages and controls the partnership.
Shareholders in MLPs (technically “unit holders”) are limited partners in the
enterprise. They own an interest in the assets of the business, which in turn
entitles them to dividends and other distributions from the business. They also
benefit from depreciation of the assets of the business.
Taxation of MLPs was established in 1987 by Congress. The partnership does
not pay taxes itself, so the distributions sent to unit holders do not qualify for
the federal 15 percent cap on dividend income. However, not all of each
distribution is a “dividend.” Some of it is a return of the original capital invested.
The returned capital, in effect, reduces the cost basis of the investment (as if the
shareholder had spent less per share in the first place). Returned capital is not
taxed in the year it is distributed, but it is effectively taxed when the unit holder
sells the shares. That is because there will appear to be more profit on the sale
of the shares, since the returned capital over the years reduced the cost basis.
So the returned capital is not, as is sometimes stated, non-taxable; rather the
taxation is deferred. When you finally sell those shares, the taxation catches up
to the distributions received over time.
Because of their unique structure and the complex tax situation, MLPs must
mail an IRS Schedule K-1 to each unit holder every year. This reports the unit
holder's share of the partnership’s taxable and non-taxable income, gain, loss,
deduction, and credits. It is really not that difficult to deal with, and any
competent tax preparer is familiar with K-1’s.
Business Development Companies (BDCs)
BDC’s were created by Congress in 1980 to help provide capital to small
businesses. They have been much in the news lately, usually under the term
“private equity,” as there have been dozens of recent deals in which companies
have been “taken private.” That means that public companies—some of them
quite large—have been bought in their entirety by private equity companies with
huge amounts of capital at their disposal.
Many of these private equity deals have been made by companies which are
truly private, but some of the private equity firms have themselves decided to
go public, becoming BDCs. (Never mind that the size and nature of the resulting
entity and its investments may be far outside the original purpose and spirit of
the law.) When a private equity firm is itself public, that means that the
individual investor has a chance to participate in “big deals” that would
otherwise not be possible.
The law requires BDCs to distribute, at least annually, the bulk of their net
investment income and capital gains to shareholders. Thus they often have
attractive dividend yields. As with REITs, these dividends are not subject to the
15% cap on dividend tax rates.
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