With interest rates at or near an all time low, income-oriented investors have been turning over every rock they can find for a decent income producing investment. This has led some investors to the world of master limited partnerships (also known as publicly traded partnerships). These investments can offer some high payouts and attractive tax benefits, but they are not as simple as certificates of deposit (CDs). Let’s peer into the realm of master limited partnerships (MLPs).
What is a MLP?
MLPs are businesses that perform specific projects defined by the IRS, mainly in the energy infrastructure space. MLPs are publicly traded on a U.S. securities exchange. MLPs, as an asset class, originated in the 1980s through laws passed by Congress that were designed to encourage investment in energy and natural resources. Some of the better-known MLPs invest in oil and gas pipelines, timber lands, and other natural resource projects.
MLPs have more attractive tax characteristics than corporations that are subject to double taxation from the view point of shareholders. The most common structure of a MLP is in the form of a limited partnership or a limited liability corporation taxed as a partnership. In a limited partnership, there are two main parties: a general partner, who manages the partnership on a day-to-day basis, and the limited partner, who invests in the partnership. Generally, the general partners bring the know-how and know-who, while the limited partners bring the money. The limited partners’ interest, known as “units,” trades on a stock exchange like the AMEX, NASDAQ, NYSE, or other publicly traded exchanges. Investors who own units in a MLP are known as “unitholders.” Like stocks, bonds or ETFs, unitholders trade their units in the partnership to each other in the market place.
Historically, MLPs have paid out distributions at higher yields than dividend payouts from common stock. In some time frames, they have greatly outperformed investment grade bonds. Most MLPs make quarterly cash distributions to unitholders, which can make them attractive to income focused investors. If the MLP business model prospers, distribution payouts can increase over time. In addition to yield, MLPs have shown a low correlation to stock and bonds, making them an interesting portfolio diversification option. Keep in mind, however, that MLPs are businesses first, and as a limited partner, your investment is on the line if the partnership fails or faces other unforeseen liabilities. Limited partners can be exposed to liabilities that seek to recapture the return of capital that has been paid out to them under certain circumstance.
Most MLPs operate in highly regulated markets, which adds political and regulatory change risks to the equation. This risk is in addition to the normal risks that investors must weigh when investing in or being a creditor of a business (e.g., investment risk, market risk, interest rate risk, etc.)
How do MLPs work?
MLPs are required to derive at least 90% of their income from specified sources, such as, rent, interest, dividends, capital gains from the sale of real property, income and gains from commodity activities, income and gains from natural resource related activities, and income from transportation and storage fees. General partners usually charge a fee or pay themselves with interest in the partnership, which can dilute the limited partner’s interest over time. MLPs pay no taxes at the company level. They pass everything through to the partners. Limited partners will receive their proportionate share of the MLP’s income and gains for the year on a Schedule K-1. The limited partner will be responsible for paying taxes at their applicable federal and state tax rates on the income and gains generated by the partnership. This applies even if the general partners do not distribute the earnings to the unitholders (i.e., phantom income). The limited partners will also receive the partnership’s proportionate share of deductions and tax credits that also pass through to their personal tax return. These items should offset some or all of the income and gains from the partnership.
When someone becomes a unitholder, the cost they paid for the units becomes their basis in the partnership. As you pay taxes on the partnership’s income and gains, your basis in the partnership increases. However, if the partnership passes through a loss, your basis is decreased. Your basis in the partnership is also decreased when the partnership pays you a distribution. All cash distributions are considered a return of capital first. This is the tax benefit to owning a MLP. Distributions are not taxable to you until your basis in the partnership reaches zero, or you sell the units at a gain (i.e., sell for more than your adjusted basis). If you sell your MLP at a gain, you will have to recapture your original basis at ordinary income rates. Anything above your original basis will be taxed at capital gain rates. Likewise, if your adjusted basis reaches zero and you have not sold the MLP, you will pay taxes immediately on all future cash distributions until you have basis again.
MLPs fall under the passive loss rules established by the IRS. These rules state that losses from the partnership cannot be used to offset other income or gains. These losses must be carried forward, and they can only be used to offset future income and gains from the same partnership. However, if after netting the income from the losses you are left with a net income situation, this income is considered portfolio income. It can be offset by other investment expenses. MLPs are also considered capital property for a step up in basis at death. This means whoever inherits the MLPs interest at the unitholders death can use the MLP’s total market value as of the date of death for their new basis.
How to own MLPs
The best place to own a MLP is in a taxable brokerage account. These investments have tax-deferred benefits already. You can own MLPs in an IRA; however, you will lose many of the built-in tax benefits that MLPs offer. In addition to losing the tax benefits, you may incur a tax liability that you would not normally be exposed to outside the IRA. This tax is called an unrelated business income tax or “UBIT.” If your IRA has more than $1,000 in income from an MLP (i.e., not the cash distributions but the proportionate share of the partnerships income), you will pay taxes at corporate tax rates—which could be higher than personal rates—on any amount over a $1,000. That means you will pay taxes in a tax-deferred (Traditional IRA) or tax-exempt (Roth IRA) account. Your IRA custodian will file an IRS Form 990T, and pay the tax liability with cash from your IRA account(s). The good news is that you would likely have to own a lot of MLP units before you could be exposed to unrelated business income tax. MLPs are not known for passing through a lot of income, because they usually take large depreciation expenses; however, it is possible. You will also forgo any capital gains treatment for proceeds above your original cost basis, if you sell your MLP in an IRA.
Master limited partnerships are companies and must be analyzed both at the company and project level to understand if the current yield is worth the risk. You can lose money in MLPs; therefore, you should seek the guidance of a professional to understand the complexities and nuances of this asset class. MLPs can offer diversification and attractive yields to your investment portfolio. However, you should understand their strengths and limitations before you invest. For more information regarding this topic, please contact Henssler Financial at 770-429-9166, or [email protected].