June 2013

June 2013 Finance: Master Limited Partnerships(MLPs)

Author: Lew Wessell | Photographer: Photography by Anne

April 15 marked the end, thank goodness, of another intense tax “busy season.” Although exhausting, each tax season, through the lens of hundreds of tax returns, also offers the tax practitioner a vivid inside look at what’s happening in the economy as well as emerging investing trends. This year, I saw a lot more completed real estate transactions and a lot fewer individual tax returns with massive capital losses. I also worked on an ever-increasing number of returns with K-1’s from Master Limited Partnerships (MLPs). As an early investor in these companies, I’m not surprised by their growing popularity. MLPs have been great performers over the past 10 years and, if you believe in the success of America’s energy business, they should do very well in at least the near future. Here’s what you need to know about this important investment opportunity.

MLPs are equity investments traded throughout the day on stock exchanges much like any other investment. Unlike most publicly traded investments, however, MLPs are not structured as corporations. They are partnerships, with investors holding units instead of shares. When an MLP pays money out to its investors, it pays them in the form of distributions, not dividends (don’t worry—it is still cash). As with any partnership, an MLP is a tax conduit or pass-through entity; it does not pay taxes, but instead files an annual “information” tax return (Form 1065) and issues each investor a Form K-1, not a 1099-Div as with corporations. The K-1 represents each investor/partner’s share of the profits and other tax attributes of the MLP. Each partner must account for these on his/her own tax return.

The vast majority of MLPs—80 percent, according to the National Association of Public Partnerships (NAPTP)—are in the energy field. This is due to the enabling section of the Internal Revenue Code (Section 7704) which restricts this preferential tax structure to companies that earn at least 90 percent of their gross income from dividends, interests, real property rents and income derived from just about anything to do with the exploration, transportation, processing, storage and marketing of natural resources such as oil, natural gas and ammonia.

Much like real estate investment trusts (REITs), MLPs are required to pay out virtually all of their earnings to unit holders on a quarterly basis. This requirement favors a business with steady, predictable earnings; thus most MLPs are basically “mid’-stream” toll-takers for the oil and gas business, i.e. they earn money for each mile a barrel of oil moves through its pipeline or each day a barrel is stored in its facility or each barrel of crude oil refined into higher grade. The price fluctuation of oil, natural gas, ammonia, etc. has, at worst, a muted effect on the earnings of these MLPs, as they are compensated solely by how many units of natural resource they transport, refine, store or market.

As can be easily surmised, an investment in an MLP is primarily a play for current steady income. In this regard, most MLPs have been wildly successful. Not only do most generate steady returns of 3-8 percent, but these returns, in most cases have grown quarter after quarter. Further, as these distributions have increased and thus the yield of the MLP along with it, the price of the MLP has also risen—often dramatically. To wit: the total return (distributions plus price increases) of the Alerian Index of 50 MLPs has increased 396 percent over the past 10 years, 120.6 percent over the past five years, and 19.8 percent just since the beginning of 2013 (through April 21, 2013).

But wait…there’s more! As if a steady return of 3-8 percent and substantial capital gains weren’t enough, consider also that much of this income is tax deferred. This deferral is due to the fact that, as a partner/unit holder, an investor is taxed on the “income” of the MLP, not the distribution. Income is the net bottom line of the MLP, and that bottom line, particularly for an oil pipeline MLP, includes large amounts of non-cash depreciation expenses on its pipeline assets. While a billion dollars of depreciation decreases income by a billion dollars, it has no effect on the amount of cash actually distributed to the unit holders. On average (not always!), only 20 percent of the cash distributed by an MLP is taxable income to its investors.

So what’s not to like? The biggest drawback for MLPs is dealing with K-1’s instead of 1099-Dividend forms. As a CPA, I love K-1’s because there is no way in the world a non-tax professional can possibly figure out how to properly account for them on his/her tax returns. So, issue one: if you invest in an MLP, count on using a tax professional to do your tax return and/or count on your current professional charging you more than he/she did in the past. Most tax pros charge for their time, and each K-1 is going to take a tax pro 15 to 30 minutes.

Another somewhat negative (and complicating) element is the fact that earnings from MLPs are currently taxed while losses are considered passive and cannot be deducted. Furthermore, as a publicly traded partnership, MLP losses cannot even be netted against earnings from other MLPs. Losses are deferred until the MLP is sold in its entirety; at that time, losses are released and netted against all other taxable income. To add to the complexity issue, a partial sale, say 50 of the 100 units you own in an MLP, should also release partial suspended losses, but the MLP will normally not be able to provide you with the necessary information to do so.

As you might expect in the financial industry, there is an alternative solution to this complexity: invest indirectly in MLPs through ETF’s and mutual funds. The largest of these are Kayne Andersen (KYE), Tortoise Energy (TYG) and the family of Oppenheimer Steelpath mutual funds. With these funds, you receive a 1099 instead of a K-1, you avoid UBI issues (see below), and you will get professional management and instant diversification. You will also get some hefty fees. As a point of reference, the Oppenheimer Steelpath MLP Income Fund A (MLPDX) charges an upfront sales fee of 5.75 percent and an annual management fee of 1.35 percent (that’s about $700 in fees on a $10,000 investment).

Another negative MLP issue is that the MLP tax benefit is a deferral, not a permanent tax savings. When you actually sell your investment in an MLP, there will be a recapture of the depreciation that saved you the taxes in the first place. This will create ordinary taxable income upon sale, not capital gains. Look for a special schedule from the MLP the year you sell and be prepared to fill out an IRS form you may not have seen before (Form 4797).

MLPs inside an IRA
The income of an MLP is considered unrelated business income (UBI) and, if UBI inside an IRA totals $1,000 or more, the custodian of the IRA must file a special IRA form (990-T) and pay taxes. This is a complicated and controversial area of taxation, and my advice would be to consult your tax pro before investing in MLPs inside your IRA. Frankly, I’d be hesitant to invest in an MLP inside an IRA anyway, since doing so eliminates the MLP’s basic tax deferral benefit. Nevertheless, if IRAs are all you have, it still may make sense for you.

MLPs to consider
I’m not a licensed stock broker and I don’t give investment advice. A good place to begin your own investigation would be your broker or the NAPTP website. As a starter, here are the largest MLPs by market cap (All four are mid-stream companies specializing in the transportation, processing and storage of energy products):

Kinder Morgan (KMP): Kinder Morgan is the largest midstream and the third largest energy company (based on combined enterprise value) in North America. It owns an interest in or operates approximately 73,000 miles of pipelines and 180 terminals.

Enterprise Products Partners (EPD): Enterprise Products owns 50,700 miles of pipelines, massive salt dome storage facilities for natural gas, 25 processing plants, six off-shore drilling platforms, and more.

Williams Partners (WPZ): Williams’ pipelines deliver 14 percent of all the natural gas consumed in the United States. Its holdings include the 10,000 mile Transco natural gas pipeline running from Texas to the New York City metropolitan area.

Plains All-American Pipleline (PAA): Plains All-American handles over 3,500,000 barrels of crude oil, refined products and NGL each day. It has 16,500 miles of pipeline as well as nearly 100 million barrels of storage capacity.

Before considering an MLP, consult with your investment advisor and tax professional to determine if the investment is appropriate for you.

To comment or for more information, e-mail lewwessel@hargray.com.

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