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My FI Journey » Investing » 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.

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.

951423_alaskan_pipeline_2Master 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.

    • Alliance Resource Partners LP (ARLP, Coal, 10 years)
    • Buckeye Partners LP (BPL, Oil&Gas Pipelines, 17 years)
    • Kinder Morgan Energy Partners (KMP, Oil&Gas Pipelines, 16 years)
    • Magellan Midstream Partners LP (MMP, Oil&Gas Pipelines, 12 years)
    • NuStar Energy LP (NS, Oil&Gas Pipelines, 11 years)
    • Plains All American Pipeline LP (PAA, Oil&Gas Pipelines, 12 years)
    • Sunoco Logistics Partners LP (SXL, Oil&Gas Pipelines, 11 years)
    • TC Pipelines LP (TCP, Oil&Gas Pipelines, 13 years)
    • Enterprise Products Partners LP (EPD, Oil&Gas Pipelines, 15 years)
    • Suburban Propane Partners LP (SPH, Propane, 14 years)

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.

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10 Responses to "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."

  1. Wow, great overview. Honestly, I’ve never heard of MLPs before. They seem pretty simple (similar to stocks) besides the taxes on them. I’m think that alone may shy me away from investing in them.

    1. MFIJ says:

      I wouldn’t be too afraid of the taxes. They are annoying at first, but you’ll get the hang of it after a couple of times.

  2. Executioner says:

    The added tax filing steps have kept me away from MLPs so far. I think if I was ever to dabble in these types of investments I would do so in the form of an ETF, to simplify things. Though the KMI solution sounds good too. It would be nice if other MLPs followed this model in the future.

    1. MFIJ says:

      The tax filing isn’t so bad. It’s a bit of a pain the first time you go through it. But after the second or third time, it gets easier. The really annoying part is how long it takes MLPs to send you the tax forms. Waiting until the last minute to do something is not my preferred way of doing things.

  3. Hi there.

    I filed schedule K-1′s in the past and did not find it to be terribly difficult. But yes it is extra work. Yes you will be waiting till late February or March before they arrive in the mail. You can also access them online (but still have to wait). Turbo Tax supposedly had a feature to import K-1′s, but I could never figure it out.

    Be careful of the upstream types (LINE, QRE, BBEP). Linn is being looked at by the SEC right now.

    WPC is now a REIT.

    Overall my experience with MLPs hasn’t been all that great. I like the fact that I have been able to defer taxes within my taxable account, but I picked the wrong ones. My picks went nowhere while the others I came close to buying did great (SXL has almost tripled). They are difficult to evaluate, that’s for sure. There is a huge energy boom right now and lots of potential here. We need the infrastructure. Unfortunately I am not skilled in finding the right investments so I decided to bow out and stick with companies that are easier to understand. No more limited partnerships for me, but I would still consider a general partner, specifically KMI.

    I see you have done well with STON and SPH! Good stuff!

    1. MFIJ says:

      Thanks for stopping by.

      The K-1′s are getting easier to fill out. When I do my taxes next year, I’m thinking that they’ll go a lot smoother. But the first time I had to deal with the K-1 (and the accompanying state tax) it was rather annoying. If Turbo-Tax can import K-1s that would be great. I’ll have to look into that and see if I can get it to work.

      I’m moving more towards general partnerships myself. I’ve got KMI and I just picked up OKE.

  4. don brown says:

    I have read it takes a minimum of $250,000 to get into a limited partnership. Is this true?

    Is there a rating service like Morningstar for limiteds?

    1. MFIJ says:

      Some partnerships which are privately traded may have minimum investments. However, MLPs are traded on public exchanges, so the minimum investment is whatever the price of one share is.

      Some MLPs are rated by services like Ford or Capital IQ. Others aren’t. I’m not sure if there is a rating service specifically for MLPs.

  5. [...] Most individuals I Know that are just getting started with dividend stocks know very little about MLPs. Check out MiFi Journey’s post that explains Master Limited Partnerships. [...]

  6. Sumflow says:

    Kinder Morgen is not a REIT. Kinder Morgan created a holding company that Sharebuilder’s can buy less than one share of Kmr in if they want. The publicly traded Kinder Morgan holding company, that holds shares in the MLP, completely avoids K-1s or 1099s because the dividends are not reported. Current yield about 7% reinvested.

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