Master Limited Partnerships

 

Interest rates have been at historically low levels for years now, which makes it easy for companies to raise money by issuing debt (which is supposed to help the economy grow) but makes it hard to live off the income from a portfolio of safe treasury and investment-grade bonds—as many retirees always expected to do.

Today, investors who need a regular income stream from their portfolio are broadening their ideas of what kind of investments belong in an income-generating portfolio. Most have already realized the potential of dividend-paying common stocks—the S&P 500 now yields more than a 10-year treasury bond—and many are looking even further afield.

One of the highest-yielding investment types we recommend is master limited partnerships, or MLPs.

Master limited partnerships are a unique type of business allowed under the U.S. tax code. They’re similar to a “regular” limited partnership, with a few differences.

In addition to a limited partner or partners, who provide the MLP with capital and get a share of its cash flow in return, MLPs also have a general partner that runs the business.

In addition, Master limited partnerships are publicly traded, by definition. The limited partners are the public shareholders—in this case called unitholders.

The primary benefit of being organized as an MLP is that the business doesn’t pay corporate taxes on its revenue. Instead the cash flow is distributed, almost entirely, to the unitholders (who are then responsible for taxes).

That makes MLPs a very efficient way to pass along the cash flow of an income-generating enterprise to public shareholders. And so they often make large regular distributions, and have very high yields.

Not just any business can be organized as an MLP though. The tax code requires master limited partnerships to derive about 90% of their revenue from natural resources, commodities or real estate. In practice, many own energy transportation or processing facilities, like oil or gas pipelines.

While they’ve become much more popular in these years of rock-bottom interest rates, most investors still have a lot of questions about MLPs. I’ll try to answer the most common ones here, and if you still have more at the end, I encourage you to reply to this email and let me know.

Question #1: How do I pay taxes on my distributions from master limited partnerships?

Because MLPs don’t pay taxes at the corporate level, you will owe tax on any MLP distributions you earn. But the distributions are heavily tax-advantaged, with most of your tax burden deferred until you sell the MLP. Here’s how it works.

MLP distributions are made based on the MLP’s distributable cash flow (DCF), which is similar to free cash flow (FCF).

This is important because an MLP’s DCF is usually much higher than its net income. That’s because MLPs have significant depreciation and other tax deductions, which lower their taxable net income significantly. (This is why certain types of businesses make better MLPs: huge tangible assets like oil pipelines have very high depreciation expenses.)

So the money comes in, the MLP pays it out as distributions to you and the other unitholders, then the MLP takes deductions on the amount and reports its taxable net income to the government.

And, as you may have guessed, you only owe taxes on the portion of your distribution that came from the MLP’s net income—which the MLP will inform you of in an annual form called a K-1.

You do have to pay regular income taxes on that portion of the distribution (not the lower qualified dividend tax rate), but it’s usually only 10% to 20% of the total distribution.

What happens to the other 80% to 90% of the distribution?

The other 80% to 90% of the distribution is considered “return of capital,” and reduces your cost basis in the MLP.

So if you buy an MLP for $50, and receive an annual distribution in your first year of $3.50, of which $0.30 is considered taxable net income, your cost basis in the investment will be reduced by $3.20 (the distribution minus the portion of the distribution that is net income), to $46.80.

You do have to pay regular income taxes on the difference between your original purchase price and your reduced cost basis when you sell the MLP (at the same time you pay taxes on your capital gains), but in the meantime, those taxes are deferred.

That’s a big benefit to many investors who want to focus on reducing their current tax liability on their investment income (because they’re living off it, or for other reasons). Plus, the cost basis of the investment is “reset” to the current market value if the original unitholder dies and passes on the investment. So the new owner won’t owe tax on the difference between the original cost basis and the adjusted cost basis.

Question #2: Can I hold master limited partnerships in my IRA?

This is a common question from investors considering buying MLPs for income.

While you are allowed to hold MLPs in a tax-advantaged account like an IRA, it is unwise.

That’s because the IRS considers MLP distributions paid into an IRA “unrelated business taxable income,” or UBTI. And if your IRA earns over $1,000 in UBTI (total from all sources, including distributions from different MLPs) in a single year, your IRA will be liable for paying tax on that income, at corporate tax rates.

However, if you do most of your investing through an IRA and would like to add the yield-boosting powers of MLPs to your account, there is a way.

Funds that specialize in master limited partnerships have given investors a way to benefit from the income-generating power of MLPs without dealing with K-1 forms and UBTI liability.

Timothy Lutts

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