Pass Through Taxation
Double Taxation & Stocks
An owner of stock in a public corporation (remember, stockholders are owners of the company) is actually taxed twice when it comes to his / her investment in the company. Why? Because the company as a whole pays taxes on the money it earns, and then the stockholder pays taxes on the dividends paid to them by the company.
To simplify this, let’s say company XYZ makes $500 of revenue in a given quarter. After subtracting all costs related to the business as well as accounting items such as depreciation and amortization, the company has $150 of profit left over. XYZ then has to pay taxes on that $150 (so now only $97.50 remains as net income).
It decides to keep 40% of this money to invest in new projects and pay out the remaining 60% to shareholders as a dividend (thus, the dividend payout ratio is 0.6). Unfortunately, shareholders must then pay taxes again on the dividends paid to them. As a result, they have effectively paid taxes twice!
Owners of Dividend Stocks are Double-Taxed
MLPs Benefit from Pass-Through Taxation
In an MLP, on the other hand, investors who invest directly in LP units only pay taxes on the cash distributed to them. That is, taxes are not paid at the entity level (like in the example above) only at the investor unit level. This is often referred to as “pass-through” taxation, and is a huge advantage for MLPs. Note that the cash distributions to LP unitholders are similar to the dividends that stockholders of a company receive. However, these payouts to direct investors will only be referred to as “cash distributions” or “distributions” in the context of an MLP (in order to distinguish them from dividends).
Next: Benefits of MLPs: Deferral of Taxes
