“A small class of dividend companies will come out on top – regardless of whether Congress raises dividend taxes.”

Ian Wyatt says you can "Dodge the Fiscal Cliff with These 3 Dividend Stocks"

By Travis Johnson, Stock Gumshoe, November 7, 2012

“January 1, 2013 it begins…

“Just 54 Days left before your dividends get thrown off the fiscal cliff…

“Most dividend investors will be wiped out by the coming tax nightmare…

“But a small class of dividend companies will come out on top – regardless of whether Congress raises dividend taxes.”

That’s the lead-in to the new teaser promo from Ian Wyatt for his High Yield Wealth newsletter, which generally looks for stocks with high dividends. So what does the teaser pitch tell us? Well, first he gets us riled up a little bit:

“If you don’t own the right dividend stocks before this upcoming fiscal cliff on January 1, 2013, there’s no guarantee you won’t see your dividend income fall substantially.

“And I don’t know about you, but I don’t like the idea of “trusting” Congress to do the right thing…

“That’s why I’m writing you this letter today.

“I believe that American investors should be fairly rewarded for risking their capital. Isn’t it enough that you’re taxed on your wages – is it fair to tax you AGAIN for having the good sense to invest in dividend stocks?”

Yes, I know, the double negatives make my head hurt too. Still, the basic idea has been lingering in retirees nightmares for a while now — what happens if investors lose the preferential tax treatment for dividends (or even for capital gains, which is a much bigger deal), etc.

If taxes on dividends go up, will the prices of blue-chip dividend paying common stocks fall to keep their after tax yield consistent? I am not particularly worried about this as a long-term issue, but that’s not to say that it won’t have some impact on share prices as part of the broader “fiscal cliff” debate and the panic that these big-picture fiscal debates generally create in the stock market. Dang, there’s that double negative again.

But anyway, Wyatt’s pitch is that regular dividend investors (presumably, the ones who don’t follow his advice) will be “wiped out” by the “tax nightmare” — and that his advice will send you down a far rosier path.

“I’ve spent much of the past year searching for dividend stocks that will weather any tax nightmare the Congress can imagine.

“In short, I’ve found 3 unique companies that will be completely unaffected by whatever terrible decisions Congress makes before the end of 2012…

“And I’ll tell you EXACTLY how to buy these companies to make sure you dodge whatever tax scheme Congress throws at us.”

Sounds pretty good, right? Well, he’s pitching the idea of these companies whose dividends are already mostly untaxed, and which will be mostly untaxed in the future even if the tax law does go rolling off that fiscal cliff:

“… what you might not know is that there’s a small, select group of dividend companies that will be almost completely unaffected by these new taxes – or any other new taxes for that matter.

“I’m talking about companies that are set up as natural (and completely legal) tax shelters…

“I know it’s hard to believe, but it’s a fact…

“A handful of American companies are exempt from this law. The dividends you receive from these companies are (and will be) almost entirely UNTAXED….

“I’ve recently found this ‘other’ group of dividend payers that have opted out of this double taxation scheme.

“Instead, they pay almost no taxes… it’s great for these companies because they can share even more of their profits with their shareholders.

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“That’s why on average, these “other” dividend companies pay out 2-3 times more.

“How? It’s simple: they keep more of their profits – and then they pay out more to you, the shareholder.

“Come January 1st, these companies are likely to be completely unchanged.

“That’s why I call these companies “Congress-Proof.”

“No matter what happens – no matter goofy laws, or back-alley deals our elected leaders come up with – these companies will remain off-limits for new taxes….

“It’s the only way I know how to make sure you’re dividend income doesn’t get sucked away by Washington DC.”

Sound nice, eh? Higher dividends, almost entirely untaxed? So what’s the catch?

Well, we’re further teased that these companies pass through their income to you, but that up to 90% of the money they send to shareholders is tax free … in his words:

“… up to 90% of all the dividends you collect from these companies are completely tax free.

“The other 10% is taxed at your earned income tax level.

“Even if you’re in the highest tax bracket, you’ll likely only be taxed the equivalent of just 3.5% on all of your Congress-Proof dividend income.”

So what’s he talking about?

Well, he doesn’t, unfortunately, get into much in the way of hinting or teasing about the specific picks he’s making … but it’s pretty clear to me from this backdrop that he’s teasing the basic idea of pass-through stocks, and that in this case he’s focusing on those that have distributions that are largely “return of capital” instead of taxable income.

There are several kinds of companies that do this routinely, including Business Development Companies (BDCs), Real Estate Investment Trusts (REITs), and Master Limited Partnerships (MLPs), though I also included in the MLP group the other publicly traded partnerships that happen to be LLCs (for our purposes they’re really the same, it mostly depends on whether or not there’s a separate General Partner pulling the strings).

In practice many of these kinds of investments perform similarly, but the most popular ones lately are the MLPs so I’ll go through the basic idea assuming that it’s MLPs he’s pitching.

MLPs are pass-through entities that aren’t designed to pay corporate taxes, so they pass along the tax liabilities on their income to you, the unitholder (they call the shares “units” and the dividends “distributions”), and you owe the taxes. Except MLPs are generally in very capital intensive industries (mostly oil and gas production, processing or infrastructure), and they have big depreciation writeoffs that don’t cost them cash but do negate much of their earnings, so there isn’t usually much income tax liability to pass along even though they have large cash flows that they can pay out to you.

Huh? Yes, these are set up as pass-through companies to pass through their earnings to unitholders … but earnings are usually pretty low. So in practice, they pay out far more than they earn in profits — but since that extra amount they pay out isn’t taxable, because it isn’t technically profit, it’s classified as a return of capital to you. Meaning, they’re giving you a portion of your investment back — so if you buy a $20 share and they pay $2 in distributions per year, perhaps $1.50 of that is return of capital and 50 cents is passed-through earnings. You’re liable for taxes right away on that 50 cents (unless it’s in an IRA or something), but the $1.50 is just your money that you’re getting back so you don’t pay tax on it.

What it does is reduce your cost basis — so now, when you go to sell your units, you would have to report that your cost basis was not $20 but instead was $18.50 after that first year. Cost basis can and does go to zero, but if you hold for that long then I think the distributions immediately become taxable — from what I’ve read, the IRS doesn’t allow for a negative cost basis. I am NOT NOT NOT an accountant and in some ways this is an oversimplification, so please talk to yours and understand all of this before investing in MLPs, don’t count on my description for your tax planning purposes.

Does that mean these are “tax free?” No, it just means they’re tax-deferred — like a 401(k) plan or an IRA, so it’s basically a way to get a nice tax deferred income stream that doesn’t have to be inside your tax-deferred account, which also means that if you want to reinvest those returns into more shares it can compound even faster because you don’t have to take taxes out first.

And add on to that the fact that MLPs tend to be good, solid “toll” businesses (pipelines and such) that are pretty predictable and have revenues that keep up with inflation in many cases, and you get a growing, tax-deferred income stream, so the fact that it comes with some (relatively minor for most people, I think) tax headaches and recordkeeping challenges isn’t enough to keep these entities from being very popular with investors. Especially when many of the big, stable ones yield 4, 5, 6, or 8% at a time when current income is hard to come by in the market. So saying that they’re “tax-free” is a bit disingenuous, though it’s a common description and they do, for many investors, have significant tax advantages.

But all of that is stuff that many of you already know — and MLPs have been a favorite among resource-oriented and income-oriented newsletter editors for many years, since they provide the things that we love: high income, some inflation protection, and enough obscurity that we can claim to be smarter or more “in the know” than our neighbors. If you want more chatter about MLPs, the folks at Stansberry recently revived their “AOP” teaser campaign that pitches a few of them and we wrote about those ideas here.

Which pass-through investments are being recommended right now by Wyatt? Well, that’s a bit trickier — he provides only a few hints. This is what he says about his first one:

“My Favorite Congress-Proof Dividend Stock

“This company pays out 90% of its earnings to its owners – and is taxed at a super low rate.

“I know I was excited to find out that this company pays an 8% dividend – and that most of that dividend is completely untaxed for American investors.

“But my primary concern is (always) the safety of that dividend.

“The good news is that according to this company’s filings, it’s their primary goal to distribute ‘funds to our stockholders in the form of monthly cash distributions.’

“And they’ve done so successfully since 2003 – raising their dividends an astounding 6 times in the process.

“This company truly puts their stockholders first – and if you doubt that fact, then you should know that 4 of the top individual investors in this company also happen to be on the board of directors.

“That’s the kind of alignment of interest that I like to see in a company I want to own for the long term.

“This company has a specific and primary goal of raising its dividend payouts because so many of its insiders receive a huge chunk of money from these payouts.

“And remember, these are monthly payouts…”

So … there are plenty of companies that have the payment of dividends as their primary goal, and even hundreds that aim to pay monthly dividends — but I can’t be 100% certain about the Thinkolator’s possible answers for this one. The best match is Gladstone Commercial (GOOD), which is a small commercial REIT that happens to have a large return of capital component in their monthly dividends, and therefore should be a little bit similar to an MLP when it comes to tax deferral (though without the same K-1 partnership forms).

GOOD has indeed raised dividends six times since 2003 (a year in which, by the way, there were no IPOs in the MLP space), but all of those dividend increases took place between 2003-2008 — the distribution has been steady for about four years now. I don’t know this company particularly well, but there’s an older analysis here from Seeking Alpha that was published back in May and might help you get a handle on what some of the important metrics are for this very small company.

The others? Well, for the others we get essentially no hints at all — other than the fact that they pay quarterly dividends, not monthly, and that their yields are now 9 and 10%. Ready for my wild guesses? Breitburn Energy Partners (BBEP) and StoneMore Partners (STON), both of which are MLPs and both of which are wild, wild guesses … really wild, absolutely no basis in reality other than the fact that they’re the right kinds of corporate structures and their yields are in the right neighborhood, and I’ve heard of them.

The basic underlying argument, as I see it, is that you should invest in stocks whose payouts aren’t currently eligible for the discounted 15% dividend tax rate that was part of the Bush tax cuts, because those stocks shouldn’t then suffer if that tax rate goes away on January 1. That would include any income investment that spits out ordinary income or unqualified dividends, including most REITs, MLPs, BDCs, and any kind of debt instruments, including some preferred stock (and as a bonus, some of those stocks — like this REIT I’ve mentioned and like most MLPs — also offer additional tax benefits in the form of tax-deferral through return-of-capital payouts).

That makes a certain amount of logical sense, though it presumes clean and perfectly rational economic behavior that we’re not likely to see, and it ignores the large holdings of folks who don’t get those qualified dividend rates anyway, or who hold shares in tax-deferred accounts so don’t care, or who simply have already seen this coming and think their Coca Cola (KO) or Johnson & Johnson (JNJ) with a safe and growing 3% yield is better than these smaller, trickier, arguably riskier investments anyway. And yes, if we see the dividend tax break go away I would presume that many REITs will gradually reprice to show slightly lower dividend yields (meaning, the shares will go up a bit because some investors will be willing to accept relatively lower yields if REIT dividends and regular stock dividends face the same tax rate) … but I don’t know that this adjustment will definitely happen, and I highly doubt that it will be rapid or cataclysmic for folks who own regular dividend-paying stocks.

So that’s about all I’ve got to get you started today — we’ve got a best guess of Gladstone Commercial for our monthly dividend payer, and we’ve got some absolutely wild guesses for other high yielders that might potentially be the Apple of Wyatt’s eye. There are hundreds of dividend lovers out there in Gumshoe Land, though, and many of you who have to live off of the payments that these investments spit out, which I’m sure means you follow them closely … so let’s open it up for the group: What are your favorite income investments that provide some tax benefit (like tax deferral with return of capital)? Do you prefer high current dividends or dividend growth? Try to look for both? Let us know with a comment below.


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