Market Playground

By Philip Trinder

How will the current default tax rate increases impact different equity investment income streams, especially dividend paying corporations compared to Master Limited Partnerships? To try and walk through the concepts let’s use the following hypothetical assumptions [1]:

• Both investments are held in taxable accounts (clearly dividend paying corporations can be held in tax advantaged accounts to avoid paying current taxes on the income stream but MLPs are intended to be held in taxable accounts).

• $1,000 of qualifying dividend income from a corporation.

• $1,000 of distribution income from an MLP with 80% of the distributions assumed to be tax deferred (typically MLPs will include some language in equity offering documents that estimate the ratio of taxable income to distributions along the lines of “you will be allocated, on a cumulative basis, an amount of federal taxable income for that period that will be 20% or less of the cash distributed to you,” the percentages vary by MLP but the larger pipeline MLPs are generally in the 20% taxable / 80% deferred range).

• Current highest tax rate on qualifying dividends of 15% and highest income tax rate of 35%.

• 2013 highest tax rate on qualifying dividends and highest income tax rate of 39.6% plus a 3.8% Net Investment Income Tax so a total effective maximum rate for both of 43.4%.

Based on those simplified assumptions here’s how the estimated numbers look:

The basic conclusion is that the pending tax code changes are comparatively more detrimental to dividend income streams in taxable accounts than they are to MLP distribution income streams, thus making MLPs relatively more attractive for taxable accounts going forward [2]. Keep in mind that these estimates are based on the current default plan so they may change substantially if the government negotiates some different agreement.

Memorial Production Partners, LP (NASDAQ:MEMP) was added to the Sprint Portfolio in December as it experienced unit price weakness in association with an equity offering done to partially finance an acquisition. After adjusting for the expected growth from the acquired oil and gas assets, the lowered unit price made MEMP the best relative value at that time versus its Upstream MLP peer group.

Rentech, Inc. (NYSEAMEX:RTK) announced and paid a special dividend of $0.19 per share in December. They also announced the early redemption of their Convertible Notes, which represented the only debt on RTK’s standalone balance sheet. RTK is included in the Sprint Portfolio based on its control and substantial ownership position of Rentech Nitrogen Partners, LP (NYSE:RNF). Rentech, Inc. took Rentech Nitrogen Partners public in November of 2011 and still owns 23.25 million RNF units (roughly 60% ownership). After taking into account the cash outflows for the dividend and debt repayment, RTK continues to appear undervalued.

[1] Please consult with a professional tax advisor these are hypothetical and oversimplified calculations for discussion purposes only and are not in any way intended to be tax advice, decoding the human genome is simpler than the U.S. Tax Code.

[2] The generic MLP position is also assumed to have a positive tax basis even after all of the distributions received, which makes the taxes due calculation equal to 20% of the distributions times the tax rates. The 80% of the distributions that are “tax deferred” reduce the tax basis in the MLP position and will be subject to “recapture” when the position is sold. Please also see footnote (1).

The above article comes from Covestor. For more information about Philip Trinder, and to view his MLP Protocol Sprint Covestor Model, visit Covestor.com.

Covestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at http://site.covestor.com/help/disclosures. For information about Covestor and its services, go to http://covestor.com or contact Covestor Client Services at (866) 825-3005, x703.