Published: November 15, 2010

I'm a good geologist... I can analyze the quality of oilfields and gold deposits. However, when it comes to keeping income streams away from the taxman, I need experts...

Yesterday, I showed you how rich investors shelter investment income from taxes with unique oil and gas partnerships:

The great thing about drilling oil wells is, you can write off about 60% of the money you spend. You get to expense all the "stuff" you use to drill. Then you get to depreciate your equipment over the first three to five years.

Say you drill a $500,000 well. Immediately, you can write off $300,000 of it as drilling costs. Then, thanks to accounting rules like depletion and depreciation, 70% to 80% of the income from that well is tax-free.

If your well works out and it pays you back your $500,000 in oil production, you are only taxed on roughly $100,000... but you keep receiving tax-sheltered income for years.

Again, the problem is those deals are generally only available to high net worth individuals. But I've found a way to make these same tax-advantaged investments in the stock market. These investments are open to anyone, whether you have $1,000 to work with... or $1 million...

I call these tax-sheltered investments "E&P partnerships." They're a kind of master limited partnership (MLP).

Most MLPs are pipeline companies, transporting oil and gas around the country. They take on a special business structure to avoid paying corporate tax… which allows them to pass on the bulk of their earnings to shareholders as dividends.

E&P partnerships are searching for and drilling oil. This is the reason they offer greater tax-sheltering benefits. You see, tax laws give big breaks to drillers. E&P partnerships transfer the tax benefits of drilling to its shareholders (in this case, you) sheltering up to 80% of our income from taxes.

If you can find an investment that can shelter even 5% of its dividends, you'll make out better, over time, than traditional dividend payers. But with E&P partnerships, we'll do much, much better than that.

Here's a simple 20-year example. We'll use two dividend-paying companies. We'll put $10,000 in each, and they'll pay us 8% per year in dividends.

What you see in the chart below is your $10,000 invested in a company paying a simple, unsheltered dividend turns into $25,000 after 20 years. However, your $10,000 invested in an 80% tax-deferred E&P partnership turns into nearly $39,000. That's over 50% more money for the same investment, over the same period.

Now... these are not completely tax-free. You must pay taxes eventually. The tax-sheltered portion lowers your cost basis (your purchase price). That means your income gets taxed at the capital-gains rate, not the higher income-tax rate.

There's even a way to keep all that money and not pay taxes on it: hold your shares forever. According to one of the tax accountants I spoke with, if you pass the shares on to your heirs, their cost basis resets to the share price when they receive it. You receive all that income tax-free... and your kids don't have to pay the bill.

So here's a way to 1) collect income that grows with the price of oil, which will rise as the government inflates away the value of the dollar... and 2) prevent that same government from grabbing a big chunk of your income.

Just a few publicly traded companies allow you to collect this kind of tax-sheltered income… although I expect to see more in the future. Here's a quick list...

The biggest risk to holders of these partnerships is a decline in the price of crude oil. I believe this risk is small: The growing nations of China and India are consuming more and more oil. At the same time, large new "easy oil" finds are almost nonexistent, and major exporters like Mexico and Venezuela (the No. 2 and No. 4 sources of U.S. oil imports, respectively) are suffering production declines.

When you combine those factors with the ongoing debasement of the U.S. dollar, the price of oil has a solid floor in the $75-a-barrel range. I wouldn't be surprised to see oil trading for more than $125 a barrel in three years. Collecting these tax-sheltered oil checks is a great way to play it.

-- Matt Badiali
Editor
The S&A Resource Report

Note: This article originally appeared on Daily Wealth