Sunday, September 16, 2007

Dividends - Three Special Corporate Forms Bring High Yields

In your search for solid dividend-paying companies, you will frequently encounter three special kinds of corporations. They have chosen to organize themselves under federal laws that allow them to avoid corporate taxation provided that they pay out, or 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 far smaller 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 to the shareholder as ordinary income. That is because the earnings were not taxed at the corporations 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 the production, processing, and transport of natural resources, plus some operations in real estate.

MLPs appear mostly in the oil and gas industry. They provide small investors a way to participate in pipeline partnerships and other oil and gas operations 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, and also to 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 the distribution sent each quarter to unit holders 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 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 capital returned over time.

Because of their unique structure and 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 partnerships 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-1s.

Business Development Companies (BDCs)

BDCs 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 companiessome of them quite largehave 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 at least annually distribute 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 for their recipients. And since the shares of BDCs trade, there is the potential for capital gain or loss associated with any public company.

Dave Van Knapp is the author of Sensible Stock Investing: How to Pick, Value, and Manage Stocks. Find out more about how to become a successful individual stock investor at => . Or go directly to the book on, where it has a 5-star rating from readers => .

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