Master Limited Partnerships
Master limited partnerships (MLP) are an alternative income producing asset that can grow like a stock. MLPs are partnerships that trade on major exchanges just like regular stocks.
List
ENP, KMP, LINE, ATN, OKS, PAA, NS, TPP, DEP, LINE, EROC, BBEP
Intro
MLPs pay no tax: they pass the dividends directly to you (so you pay the tax). Many MLPs allow depreciation so 80% to 90% of the profit they generate can be written off; in other words you do not pay tax on 80% to 90% of the distribution until you sell the MLP or the tax basis reaches 0. The rest of the distribution is taxed.
Focused MLPs, such as pipelines, are not correlated to the stock market (i.e. S&P 500) in general which adds stability to your portfolio.
Structure
MLPs have a general partner and limited partners. The general partner manages the operation and individual investors are limited partners. The general partner receives a percentage of the profits off the top, before the limited partners get their cut. MLPs, though, pay big dividends because they don’t have to pay federal income taxes if they pay out most of their cash flow to shareholders. Because MLPs are partnerships, not corporations, some special terminology is involved. Specifically, you own units instead of shares, and an MLPs payouts are called distributions instead of dividends.
Risks
The main threat to MLPs is an economic slowdown, which could reduce transportation volumes and demand for their services. U.S. energy demand is expected to grow at an average annual clip of about +1% over the next two decades, approximately what it has over the previous two.
Since MLPs give out substantially all of their cash to unitholders, they depend entirely on outside financing for growth initiatives.
The tax rate, such as qualified dividend rate, is raised.
While regulated pipeline operators offer stable cash flows, if competition increases, payments to investors could decrease. Regulated pipelines receive a tariff indexed to inflation. These payments also build in a +10-12% return for the operator. That said, the tariffs represent the top rate a company can charge its customers for shipping oil and gas. When competition heats up, companies will offer their services below the going rate.
One other thing to watch for are interest rates. MLPs generate stable cash flow whether interest rates move up or down. However, just like every other income-paying asset class, MLPs compete directly with lower-risk fixed-income investments. If lower-risk bonds offer equally-attractive returns, then investors will rotate money out of higher-risk MLPs and into lower-risk bonds.
Another caution: the hefty MLP management rake-off. Managers, who own a chunk of MLP shares and thus get the same nice dividends you do, also are entitled to increasing payouts as the distribution increases. Their take can reach as high as 50%. The idea is to motivate management to expand the business.
Rewards
The midstream energy sector has high barriers to entry. Due to the high cost of constructing midstream energy assets and the difficulty of developing the expertise necessary to comply with the regulations governing the operation of such assets, the barriers to entering the midstream energy sector are high. MLPs with large asset bases and significant operations enjoy a competitive advantage over others seeking to enter the sector.
Tax considerations
MLPs maximize their tax advantages by owning long-lived assets that generate lots of depreciation-mostly long-distance pipelines, but also riskier things like gathering systems (pipe that connects to wells), storage tanks, even barges. Partnerships also pay out nearly all of their cash flow. But thanks to those depreciating assets, most of these distributions are considered a return of capital. That means you generally aren’t taxed on MLP payouts until you sell, or until your total income exceeds your initial investment.
MLPs offer a possible tax advantage because roughly 80% to 90% of distributions are considered a return of your original investment (which is really just an allowance for depletion or depreciation) instead of income. Thats great if you are a long-term investor, because you don’t pay taxes on that part until you sell or your tax basis reaches 0. However, when you do sell, you pay taxes, mostly at ordinary income rates, on the portions previously designated as return of capital. The remaining 20% is the income portion and is generally taxed at your ordinary income tax rate the year it is received.
If the owner of the security passes away, the reduced cost basis is stepped up to the current share price. That makes MLPs good for estate planning purposes, since they don’t trigger a tax liability for your estate.
There is another complication if you hold MLPs in a tax-sheltered account such as an IRA. If you receive MLP distributions totaling more than $1,000 in a year, the amount exceeding that figure may be considered unrelated business income (UBTI) and subject to taxes. So consult with a tax expert if you fall into that category.
MLPs do not pay taxes, thus allowing for a higher cash flow payout to shareholders. This is different from regular corporations, which are subject to double taxation of dividends. The corporation’s earnings are taxed and then the stockholder’s dividends are also taxable. The amount of a MLPs distribution that is shielded from ordinary income taxes is generally expressed as a certain percentage of the distribution. As an example, an 75% tax-deferred distribution would indicate that on a $2.00 per unit annual distribution 75%, or $1.50, would be tax deferred and $0.50 would be taxed as ordinary income in the year received. The tax deferral percentage amount could slowly decline over the years. However, the amount deferred can vary depending on the amount of cash distributions, the number of shares outstanding and the amount of additional taxable income related to acquisitions or growth. This is important… acquisitions sort of reset (or increase) the amount of the tax deferred portion of the distributions.
The portion of a cash distribution that is not taxable must be subtracted from you original purchase price to compute your new cost basis. When you sell, some of your gain will be taxed at the lower capital gains rate, but the portion of the gain that results from deductions such as depreciation lowering your basis downwards will be taxed as ordinary income.
Cash distributions from MLPs reduce a unitholder’s tax basis in the investment and are not taxable to a unitholder as long as the unitholder’s tax basis in the MLP exceeds zero. Distributions are taxable to the extent they exceed a unitholder’s tax basis in the investment. Unitholders may also be subject to income tax reporting requirements in states in which the MLP has operations.
Distributions
Distributions are made on a quarterly basis so check your MLP for its distribution schedule.
Tax Forms
MLPs mail individualized K-1 tax forms to unitholders in late February or early March of each year. The K-1’s are not a big deal at all and most MLP’s have very helpful websites for dealing with these things. Cash distributions are not taxable but are treated as a reduction in a unitholders original cost basis in the investment. Since MLPs generally pay out more cash distributions than the amount of taxable income, the cost basis for each individual unitholder is decreased by the difference between total cash received and taxable income reported. The MLP form allows for the pass-through of depreciation (a non-cash expense) to unitholders. The cumulative tax-deferred portion of the distribution becomes taxable as ordinary income in the year the units are sold, allowing investors the flexibility to recognize taxable income in any given year.
MLPs require the use of special forms at tax time, which some investors consider too complicated. They are the K-1 partnership. The return of capital lowers your tax basis in the stock and thus raises your capital gain down the road. Schedule E: Supplemental Income and Loss, and out-of-state returns that may need to be filed for individual MLP securities. And depending on how the MLP deals with depreciation, you could get thrown into the harrowing alternative minimum tax.
State Taxes
Investors in MLPs that operate in several states must file in each state the MLP does business. This can be a cumbersome and laborious process. The tax material the partnership sends you should include a breakdown of your net income in each state where it operates. Usually the per-state amounts are pretty low, and you may be below the state filing threshold — but if not, you’ll need to file and pay state tax.
Here is a direct example:
Q: What states do I have to file tax returns in as a result of owning TC PipeLines, LP common units?
A: In addition to the filing requirements of the state in which you live, you may be required to file a non-resident tax return in the states in which the Partnership operates. The Partnership operates in eleven states, nine of which impose income tax on a Partner’s share of Partnership income allocable [sic] to such state. These state are California, Illinois, Indiana, Iowa, Minnesota, Montana, Nebraska, North Dakota, and Oregon.
Tax Example
You don’t pay taxes on the return of capital portion until you sell the security, making MLPs ideal for long-term investors. Return of capital distributions lead to a reduction in your cost basis. For example, if you pay $50 a share for an MLP and receive a $5 return of capital distribution this year, then the cost basis of your shares will decline to $45. Say you sell the shares next year at $55 a share. You will be taxed at your ordinary income tax rate on the $10 in capital gains ($55 less $45).
Another example
Original cost = $20
2007 2008
cost basis 20.00 19.10
distribution 1.00 1.08
yield 5% 6%
10% taxable 0.10 0.11
90% deferred 0.90 0.97
Adj basis 19.10 18.13
Sale Price 27.00
Taxable gain 8.87
cap gains tax 7.00
ordinary income tax 1.87
cap gains rate = sale price - initial cost
ord. income rate = taxable gain - cap gains rate
Analysis Tools
To see the dividend history:
1 - go to finance.yahoo.com
2 - enter stock symbol
3 - historical prices > Dividends only > Get prices
Strategies
You can’t analyze an MLP the same as you would a regular stock. MLPs own lots of assets that result in large depreciation charges that subtract from reported earnings, but don’t affect the cash flow that fuels distributions. Your best prospects are MLPs with a strong distribution growth history and plenty of pipeline construction projects underway.
You can learn about an MLP’s expansion plans by reading the management summary portions of their quarterly and annual reports. You can see the SEC reports on Yahoo by selecting SEC Filings and then looking for reports labeled 10-Q (quarterly) and 10-K (annual). Once you’ve found a report, select Summary to read the management’s discussion.
Each MLP is operated by a general partner, who generally has a 2% ownership stake in the partnership and is eligible to receive incentive distributions. When evaluating an MLP, it’s smart to examine a partnership’s distributions agreements. Incentive distributions are typically based on achieving
predetermined pay out levels. Often general partners can earn between 15% and 50% of excess cash flow paid out above the target threshold.
Variations
There are four sectors of natural resource-related MLPs:
1- pipelines
2- propane distributors
3- coal
4- oil and gas exploration and production (E&P).
The pipeline MLPs are considered more conservative and are characterized by stable cash flow and slow growth. Propane distributors are more aggressive investments than pipelines. The propane industry is a non-regulated, seasonal, slow-growth industry with moderate exposure to commodity prices. Coal MLPs also have moderate exposure to commodity price volatility. However, their principal end-user customers are public utilities, thus, overall risk is considered relatively low. The riskiest are the E&P MLPs
Generally, the MLP distribution (similar to a dividend) is not guaranteed. Most MLPs (like corporations) have restrictive debt covenants, which can impair distribution payments if a default occurs.
Closed End MLP Funds
There are a few closed-end MLP funds. The following describes the major factors associated with them:
Pros
- You get a diversified professionally managed portfolio of MLPs.
- You get a single Form 1099 with a significant portion of the income considered as a tax-deferred return of capital. This is nondividend distributions and reduces the cost basis of shares owned.
Cons
- The advisers are paid a fee, around 1% to 1.5%, and incur expenses associated with overseeing the fund investments.
- These funds are structured as taxable corporations and as such, may incur income tax liabilities.
- The funds generally use leverage, which would cause increased risk affected by rising interest rates.
- Fees, taxes and interest expense will come from income available for dividends.
Tracking Indices
An index for MLPs exist called the Alerian MLP Select Index. Symbol is AMZ.
The website Alerian has more information on the index.
There is an ETN (exchange traded note) that tracks the Alerian MLP Select index under the symbol BSR. The investment seeks to replicate, net of expenses, the Alerian MLP Select Index. The index measures the performance of midstream energy oriented MLPs. These companies are engaged in the exploration, marketing, mining, processing, production, storage or transportation of any mineral or natural resource.