June 29, 2012
Written By Chloe Lutts Jensen
MLPs are easy to buy and sell; they trade on major exchanges just like regular stocks, and usually cost the same to trade.
There are restrictions on what kind of enterprises can receive MLP treatment: their primary business (generating about 90% or revenues) has to be real estate, commodities or natural resources. Most MLPs are in the energy sector—pipelines are especially common, as they generate regular, fee-based income with little activity. But there are more unusual MLPs too: one, StoneMor Partners LP (STON), owns and operates cemeteries.
The reason so many MLPs are pipelines is that MLPs are a bit like pipelines themselves—they’re special entities created specifically to pass cash along to their owners. MLPs have two kinds of owners—the general partner, which is a person or another company (often also public) responsible for running the MLP, and the limited partners—who are investors like you. Limited partners in MLPs are called unitholders instead of shareholders.
MLPs distribute most of their cash flow to those unitholders on a regular basis, much like a company paying dividends, except the payments are called distributions instead of dividends. (They’re also taxed differently, which we’ll get to later.)
MLPs also make payments called incentive distributions to their general partner (or GP). Incentive distributions are usually based on how much cash the MLP handed out unitholders—so the more money unitholders get, the more money the GP gets. It’s the GP’s job to run the MLP, so it makes sense that the more cash it generates, they better they’re paid.
The incentive distribution formula is one factor worth considering when buying an MLP: if the GP’s cut becomes too inflated at the highest levels, unitholders may not see much additional cash when an MLP increases revenues. Excessively high incentive distributions can also make it hard for MLPs to spend money—whether through capital expenditures, debt service or acquisitions—in order to grow.
The main reason for an entity to be structured as an MLP is to receive a special tax status that makes it easy (and tax-efficient) for it to pass almost all its earnings along to its owners—the GP and you. As Roger Conrad and Elliott Gue, editors of MLP Profits (and thus experts on the subject) explain in one of their reports on MLPs:
“Unlike regular corporations, MLPs don’t pay any corporate-level tax. Instead, these partnerships pass through the majority of their income to investors in the form of regular quarterly distributions. Each investor is responsible for paying tax on their share of distributions received.”
That does make the taxes a bit trickier for unitholders. But it can be worth it when you own an MLP yielding 8%, 9% or more. The different kind of taxation can also provide a tax advantage for investors.
Conrad and Gue are experts on the subject, so I’ll let them explain:
“Because MLP distributions aren’t dividends, MLP unitholders don’t get a Form 1099 at tax time. Instead, unitholders receive a form K-1—a standard partnership form that’s typically mailed to unitholders in March.
“But there are some big tax benefits to owning MLPs. Because of depreciation allowance, 80% to 90% of the distribution you receive from a typical MLP is considered a return of capital by the IRS. You don’t pay taxes immediately on this portion of the distribution.
“Instead, return of capital payments serve to reduce your cost basis in the MLP. You’re not taxed on the return of capital until you sell the units.
“In other words, 80% to 90% of the distribution you receive from the MLP is tax-deferred. The remaining piece of each distribution is taxed at normal income tax rates, not the special dividend tax rate. But as the piece taxed at full income tax rates is only 10% to 20% of the total distribution; there’s still a huge deferred tax shield for unitholders.
“An example can provide a useful illustration. Assume you own an MLP purchased for $50 and receive $5 in annual distribution payments, $4.50 of which is considered a return of capital. After one year, your cost basis on the MLP would drop to $45.50 ($50 minus $4.50); no income tax is paid on that $4.50. You’d pay normal income tax rates on the remaining 50 cents.
“When you finally sell the units or the cost basis drops to $0, a portion of the capital gains are taxed at the special long-term capital gains tax rate. The remainder is taxed at your full income tax rate.
“But in most cases, MLPs should be held for long periods to get the full benefit of distributions. You’re likely to be deferring 80% to 90% of your taxes for several years or perhaps indefinitely—a tremendous benefit for most investors.
“Many investors find the term ‘return of capital’ confusing. This is simply a tax term; it doesn’t mean that the partnership is literally giving you back your investment. Recall that MLPs are pass-through entities: For tax purposes only, it’s as though unitholders generated the partnership’s earnings for themselves. Net income generated by the MLP is allocated proportionally among individual investors.
“In addition to income, MLPs are also able to pass through other deductions and tax credits such as depreciation. It is these passed-through tax credits that generate tax-deferred return of capital.”
Conrad and Gue also provide their subscribers with more detailed information on how to file a tax return involving a K-1, but I won’t go into that here. If you’re interested in making MLPs a significant part of your portfolio, their newsletter is a must-read anyway. (Of course, having an accountant prepare your taxes is another option.)
On a final note, one frequent question that arises concerning MLPs is whether they can be held in a tax-advantaged retirement account, like an IRA—and whether it’s a good idea.
Gue and Conrad say, basically, no. In their own words: “Although you can technically hold individual MLP units in an IRA and other tax-exempt investment vehicles, don’t do it. Placing investments that are already tax-advantaged in a tax-sheltered account isn’t the most efficient allocation of resources; hold MLP units in brokerage accounts and keep your IRAs and 401(k) plans for more traditional fare.
“And there’s an even more compelling reason not to put MLP units in IRA accounts: The Internal Revenue Service (IRS) classifies some income generated by PTPs [publically-traded partnerships] held in IRAs as unrelated business taxable income (UBTI). That means if total UBTI—not the distributions—associated with one or more MLPs exceeds $1,000, the plan administrator will be forced to file a return and pay tax from available funds.”
Carla Pasternak, editor of High-Yield Investing, which also recommends many MLPs, adds: “If you do go over the $1,000 limit on UBTI, your IRA custodian will need to file IRS Form 990-T on your behalf. The distributions will be taxed at corporate rates, since it’s the tax-deferred account that’s taxed, not you personally. Moreover, a typical charge for the paperwork is about $200 for each MLP you own.”
However, Pasternak does have a suggestion for yield-hungry investors investing mainly through tax-deferred accounts: “[If] you really want to hold MLPs in a tax-deferred retirement account, you have a surprising number of choices—closed-end funds which specialize in MLPs, preferred stock issued by a couple of these closed-end funds, and exchange traded notes (ETNs) which invest in MLPs. Funds, stocks, and debt—these are all asset classes that you CAN hold in your IRA or tax-deferred account. They don’t generate unrelated business income and throw off the type of income that is reported on a standard 1099-DIV form.”
That’s the basics of MLPs. If you’re interested in more in-depth tax advice, specific MLP recommendations, or recommendations of CEFs, ETNs or preferred stocks that offer exposure to MLP yields, consider subscribing to Roger Conrad and Elliot Gue’s MLP Profits, Carla Pasternak’s High-Yield Investing or my newsletter, The Dick Davis Dividend Digest.