A Brief Primer on Master Limited Partnerships (MLP) Part 1: What are MLPs, how do they work, and why should you consider investing in them.

Master Limited Partnerships (MLPs) are unique investments that offer high yields and diversification into commodities.  Simply put, MLPs are publicly traded partnerships.  Just like stocks, they are completely liquid investments that are bought and sold on the major exchanges.  Many MLPs also have a solid history of consistently raising dividends, making them great additions to a dividend growth portfolio.  Unfortunately, MLPs come with some interesting tax filing regulations, that you need to be aware of – but never intimidated by.  Read on, and we’ll begin to explore the world of MLPs together.

How do MLPs make their money?

In order to be classified as an MLP, the IRS dictates that the partnership must generate at least 90% of income from qualifying sources.  “Qualifying sources” is however, very broadly defined.  There are MLPs out there that specialize in real estate, shipping, oil, coal, natural gas, propane, cemeteries, and timber.  Oil and gas pipeline MLPs are some of the more common ones, and tend to be favorites of the dividend growth investing community.

MLPs are often in very stable, but slow growing industries.  So while you can expect a high yield coming from your MLP investments, don’t expect much in the way of unit (share) price appreciation.

 

Structure of Partnerships

While you don’t need to know how MLPs are structured to be able to invest in them, understanding where you fit in as a partner is probably a good idea.  There are two basic kinds of partners in an MLP:

• Limited Partners (This is you) - Your job as a limited partner is to provide capital (money) to the MLP.  You do this by units (aka: shares) of the MLP.  In return for your capital, the partnership pays you distributions (dividends).
• General Partners - General partners are responsible for actually managing and running the MLP (your responsibilities end after you’ve opened your wallet) and are paid more than limited partners.  Usually, the general partners receive compensation in a way that is linked to the performance of the business.

This probably doesn’t sound very different from investing in stocks.  For all practical purposes, as far as the individual investor is concerned, there isn’t a difference.  But as far as the IRS goes, there are big differences – both in what business activities an MLP is allowed to partake in, and how taxes are dealt with.

 

MLP Glossary

Words to familiarize yourself with to move more easily through the world of MLPs.

• Distribution - The cash that the MLP gives you.  Much like a dividend.
• Unit - You buy units of an MLP, the same way you buy shares of a stock.
• Unitholder - Someone who owns units of the MLP.  Much like a shareholder.

 

 

Taxes and MLPs

Nothing ever becomes simple when the IRS gets involved.  MLPs are no exception.  First off, the good news – by obtaining MLP status the partnership doesn’t have to pay any taxes on its earnings.  The money will be taxed only when unitholders receive their distributions.

In order to appropriately file your MLP related taxes you will need a K-1 form, which specifies your share of the partnership’s taxes.  MLPs send out this form to all unitholders.  While yet another form sounds bad, it’s really pretty simple to work with.  At least as far as tax forms go.  But there’s a downside.  While your employer and your financial institutions are supposed to send your tax forms out by the end of January, MLPs get a pass on this rule.  So they tend to wait, and wait, and wait a little bit more.  March is not an uncommon time to receive your K-1.  If you’re a tax procrastinator, you probably won’t even notice the wait.

 

Taxes and MLPs – But wait, it gets more complicated

At this point, I should probably stop and remind everyone that I am NOT a tax adviser, or a tax lawyer, or a tax anything.  MLP taxes get complicated.  If you’re looking to be more clever than just copying numbers off your K-1 form and into some tax software, go seek out an actual tax professional.

The main point: MLPs are tax advantaged because most of the distributions are classified as “return of capital” rather than as income.  You don’t pay any taxes on the distributions classified as return of capital until you sell the MLP.  When you do sell, you’re stuck being taxed at the “ordinary income” rate, not the cushier “capital gains” rate.

Getting more in depth: By now, we’ve established that MLP doesn’t pay taxes, but that unitholders do.   We’ve also established that your share of the MLP’s income, gain, deductions, losses, and credits will be reported to you on the K-1 form.  You type these numbers into your tax forms and then pay taxes on the MLP’s income at whatever your tax rate is.  But how those taxes get computed and when they come do gets tricky.

• Net losses from the MLP are carried forward and used against future income from the MLP.  Extra losses will be applied against other income when the MLP is sold.
• Some distributions count as “return of capital”.  These are deducted from the cost basis of the MLP.
• Your cost basis is adjusted downwards by any return of capital.  And adjusted upwards by your share of taxable income from the MLP.
• So long as your adjusted basis is above zero, tax on your distributions is deferred until you sell your units.

 

MLPs in your IRA?:  It is also a good idea to consult an actual tax adviser before placing an MLP in an IRA because there is a risk that your distributions could be counted as unrelated business taxable income (UBTI) – which is bad.  However, if the total of your UBTI is not more than $1,000 per year, then you’re okay.  See why you should be consulting a tax professional about this?

 

Taxes and MLPs – Solutions for people who hate complexity

If you just read the above section and have no idea what the hell is going on, don’t feel bad.  I can just barely grasp the tax structure of MLPs myself.  Also, know that you are in good company – most people can’t figure out what the hell is going on tax-wise with MLPs.

Some MLPs have come up with a solution to this adventure in over-complication.  For example, Kinder Morgan Energy Partners (KMP)(*) is an MLP that owns and manages pipelines that transport natural gas, refined petroleum products, crude oil, and carbon dioxide (CO2).  They created a holding company called Kinder Morgan Incorporated (KMI) which holds general and limited partnership units of KMP.

Why is KMI holding KMP?  Because KMP is set up as a partnership, while KMI is set up as a corporation.  Since KMI is set up as a corporation, it issues regular boring common stock.  KMI pays a nice dividend and does not come with any of the tax complications that KMP does.(**)

 

Why invest in MLPs?

1. Diversification into commodities - MLPs allow easy diversification into commodities and commodity related industries such as oil and gas pipelines, coal, timber, and propane.

2. High yields - Because MLPs are “pass through” organizations, they don’t have to pay taxes on their earnings, thus allowing a greater portion of their net earnings to be distributed to their unitholders.  Many MLPs have yields within the 4% to 10% range.

3. MLPs can show solid distribution (dividend) growth - Some MLPs have characteristics of good dividend growth stocks – a minimum of a 10 year history of increasing dividend payments.  Here’s a short list of some REITs with a consistent history of increasing dividend payments pulled from the dividend contenders list. Ticker symbol and industry are included.

W.P. Carey & Co. LLC (WPC, Real Estate, 15 Years)

 

Conclusions

MLPs can be a valuable addition to your dividend portfolio, giving you exposure to a variet of different commodity and commodities related industries.  MLPs tend to produce high yields, and some companies exhibit all the characteristics of dividend growth stocks.

MLP taxes can get crazy.  But I wouldn’t let that deter you from investing in an MLP.  Select great investment first, and worry about taxes when they come.  Unless you are planning on directing a substantial portion of your portfolio to MLPs, it’s unlikely that the taxes will be worth worrying over.

(*) KMP receives much love from the dividend growth investing world.

(**) If receiving additional shares (rather than dividends) excites you, KMP offers yet another flavor of holding company, Kinder Morgan Management (KMR).

Disclosure:  I am long SPH and KMI.