MLPs for tax-deferred accounts

Master Limited Partnerships are very good investment vehicles for individuals looking for high current dividend income. There are some tax issues with reporting MLP income in a taxable account, which led me to explore investing in MLPs through an IRA or ROTH IRA account.
In a taxable account, most of the distributions are considered a return of capital, and thus you do not pay taxes on that portion. This tax deferral does decrease your cost basis however, which could mean higher capital gains or ordinary income taxes if you sell. Because of the supposedly complicated tax returns from MLPs, some investors are shunning MLPs as a class althogether. Others are considering simply purchasing those MLPs in a tax advantaged account, and forget about them.
For non-taxable accounts however, there is a gray area from a tax perspective whether or not one could hold MLPs there. The distributions that an individual that holds a master limited partnership in an individual retirement account receives could be considered unrelated business taxable income subject to taxation. As long as the UBTI from all MLPs in an IRA does not exceed $1000 in a given year, your partnership distributions won’t be taxed.
If the UBTI does exceed $1000 however, the custodian that holds your IRA would have to file a form 990T to the IRS. The tax is paid out of the IRA on the net income from your MLP distributions, which are taxed at the corporate rate.
The UBTI has generally been a non-issue for most MLPs over the past few years, but this isn’t guaranteed. Some like Kinder Morgan (KMP) have even had a negative UBTI in some years, which could be offset against any positive UBTI amounts from other MLPs. Kinder Morgan is one of my Best High Yielding Stocks for 2009.
I do believe however that paying a small tax out of your MLP distributions in an IRA shouldn’t be a big hassle, since distributions are rich and taxed at the corporate rate. One should check with their IRA custodian however in order to asses the amount of fees that the IRA has to pay if the UBTI threshold is exceeded.
If you do not feel comfortable putting ordinary master limited partnerships in a tax-deferred account but feel that you might be missing out, there are still workarounds for this situation. There is an easy way to invest in two MLPs without worrying about taxes too much – Kinder Morgan (KMP) and Enbridge Energy Partners (EEP). They pay their distributions directly as additional shares, which is similar to automatic dividend reinvestment. If you choose to invest in KMP or EEP in an IRA, consider investing in KMR and EEQ.
KMR and EEQ are great vehicles for taxable accounts as well since their distributions are not taxable when received, and thus shareholders are not issued an annual 1099 tax form. You would pay taxes only when you sell your units.
The taxation characteristics of your investments are just one part of the investment puzzle. Always make sure to investigate the company’s fundamentals and do your homework before investing in stocks.

Several publicly traded closed end funds such as Tortoise Energy Infrastructure Corporation (TYG), Tortoise Energy Capital (TYY), Tortoise North American Energy Corp. (TYN), and Kayne Anderson MLP Investment Company (KYN) provide a proper diversification within the MLP sector. They are suitable for IRAs since they send out Form 1099-DIV instead of K-1, which also makes it easier for investors with taxable accounts to file their annual tax returns. In most cases the dividends received are treated as a return of capital, which reduces your cost basis. In such cases the distributions are not treated as taxable income. Investors would only have a tax liability when they sell their closed end fund.
These closed end funds also do not generate any unrelated business taxable income (UBTI). The main disadvantage of these closed end funds are their steep annual management fees.

Tortoise Energy Infrastructure Corporation (TYG) has an annual management fee of 0.95% plus a 0.19% charge for other expenses for a total annual expense ratio of 1.14%.Tortoise Energy Capital (TYY) has an annual management fee of 0.95% plus a 0.25% charge for other expenses for a total annual expense ratio of 1.20%.Tortoise North American Energy Corp. (TYN) has an annual management fee of 1.00% plus a 0.71% charge for other expenses for a total annual expense ratio of 1.71%.

Kayne Anderson MLP Investment company (KYN) spots an annual management fee of 2.50% in addition to other fees of 3.40% for a total expense of 5.90%.
Because of high expense ratios, I would think twice before investing in those closed end funds. One thing that is certain in the investment world is that higher fees are not necessarily indicative of superior investment performance. If you cut your costs to the bone, you are much more likely to at least track your index benchmark.

Full Disclosure: Long KMR

Get an updated Trend analysis for KMP and EEP.

Relevant Articles:

- Master Limited Partnerships (MLPs) – an island of stabiliity for dividend investors
- Kinder Morgan Energy Partners (KMP) Dividend Analysis
- Best High Yield Dividend Stocks for 2009
- General vs Limited Partners in MLP's

General vs Limited Partners in MLP's

There are two types of partners in a Master Limited Partnership structure, a general partner and limited partners.
The general partner manages the master limited partnership and typically holds a 2% economic interest in it. The general partner also receives a percentage of the profits off the top, before the limited partners get their cut. These so called Incentive Distribution Rights allow the general partners to take a higher proportion of incremental amounts over a certain threshold levels. This provides the general partner with a strong motivation to raise distributions to unitholders, which is appealing to them.
The last tier is typically 50/50, which means that general partners receive 50% of any incremental cash flows above a certain threshold level. This could however increase the cost of equity for the MLP and dilute ownership claim of limited partners.

Limited partners are not involved in the day-to-day management of the MLP, and have limited liability. Once the MLPs reach the highest IRD threshold the distribution growth for Limited Partners slows down, while it increases for general partners.
Some MLP's such as Kinder Morgan (KMP), energy Transfer Partners (ETP) and Oneok Partners (OKS) have already reached the top 50% IDR level. Other MLPs such as Entrerprise Products Partners (EPD) have capped their incentive distribution rights threshold to a maximum of 25%. Check my analysis of Kinder Morgan Partners (KMP).
One way to capture the higher distribution growth potential is to purchase the General Partner Units traded on US exchanges. Not a lot of GPs are traded however. One general partner that has reached the 50% incentive distribution rights threshold is Energy Transfer Equity (ETE), which is the GP for Energy Transfer Partners (ETP).

Another major General Partner, whose units could be bought by ordinary investors is Enterprise GP Holdings (EPE). It owns the general partner and limited partner interests in Enterprise Products Partners L.P. (EPE), TEPPCO Partners, L.P (TPP) and Energy Transfer Equity, L.P (ETE). Check my analysis of Teppco Partners L.P..

Full Disclosure: Long Kinder Morgan Partners

Relevant Articles:

- Master Limited Partnerships (MLPs) – an island of opportunity for dividend investors
- Using DRIPs for faster compounding of dividends
- Best High Yield Dividend Stocks for 2009
- Kinder Morgan Energy Partners (KMP) Dividend Analysis
- TEPPCO Partners (TPP) Dividend Analysis

Master Limited Partnerships (MLPs) – an island of stability for dividend investors

Master Limited Partnerships are limited by US Code to only apply to enterprises that engage in certain businesses, mostly pertaining to the use of natural resources, such as petroleum and natural gas extraction and transportation. They combine the tax advantages of a partnership and higher dividend yields with the day to day tradability of common stocks.
MLPs consist of a general partner who manages the operations and limited partners who own the rest of the units for the partnership. Unlike corporations MLPs are not subject to double taxation.
Their stocks are called units, while their dividends are called distributions. The units are very easy to buy and sell, as they trade just like any other stock on NYSE, Nasdaq and AMEX.

MLPs mail individualized K-1 tax forms to each unitholder in late February or early March of each year that specifies the tax treatment of the prior year's payouts. A portion of their payouts can be tax-deferred, and it is subtracted from ones cost basis. When you sell your units, some of the gain that comes from certain deductions such as depreciation expense will be taxed as ordinary income. Because of MLPs specific legal structure, investors should consult with their tax advisor before investing in them.

The majority of Master Limited Partnerships engage in the transportation and storage of natural resources such as refined petroleum products and natural gas.

Thus MLPs typically enjoy toll-road business models. Thus:

- They do not take title to the commodities transported
- Are mostly indifferent to fluctuations in commodity prices because they are paid to transport not produce commodities
- They do not have significant credit risk as commodity prices balloon.
- MLP’s receive a fixed fee for moving a product over a certain distance through their pipelines

Other qualities that enable these stable enterprises to keep increasing their dividends over time include:

-Long Useful Lives of their assets
-Fees are indexed to inflation, which provides an inflation hedge
-Most MLPs have a near monopoly in their area
-There is a high cost of entry and thus there is virtually no competition

There are different types risks to investing in MLPs as well, including Regulatory Risks, Interest Rate Risks and Liability Risks.

MLPs are subject to Regulatory Risks. Currently most partnerships enjoy a pass through taxation of their income to partners, which avoid double taxation of earnings. If the government were to change MLP business structure, unitholders will not be able to enjoy the high yields in the sector for long. In addition to that since the fees that MLP charge for transportation of oil and gas products through their pipelines are regulated by the governments, this could affect the revenue stream negatively.

MLPs also carry some interest rate risks. During increases in the interest rates by the FED in 1994, 1999 and 2004 the partnerships didn’t produce decent returns to shareholders. Because of the ability to grow their cash flow base, MLPs could relatively outperform in a rising interest rate environment.

Liability risk -Unitholders typically have no liability, similar to a corporation's shareholders. Creditors however have the right to seek the return of distributions made to unitholders if the liability in question arose before the distribution was paid. This liability stays attached to the unitholder even after he or she sells the units.

The benchmark for Master Limited Partnerships, the Alerian MLP Index, has enjoyed above average annual total returns of 11.90% from 1995 to 2008. Part of the strong performance could be attributed to the above average distribution yields that most MLPs enjoy, coupled with strong growth in distributions. Master limited partnerships generate predictable and growing cash flows, which are somewhat immune to commodities price volatility and overall economic conditions. Despite the fact that the Alerian MLP Index lost 36.90% in 2008, the index is virtually unchanged so far in 2009.

The five MLPs with highest weights in the index include:

Kinder Morgan Energy Partners (KMP) owns and operates natural gas, gasoline, and other petroleum product pipelines. Also operates coal and other dry-bulk materials terminals and provides CO2 for enhanced oil recovery projects. KMP has managed to increase annual distributions by 13.90% on average since 1993. The partnership’s units currently yield 9.10%. Check out my analysis of Kinder Morgan, which is one of my best high yield stocks to own in 2009.

Enterprise Products Partners (EPD) owns onshore and offshore natural gas, natural gas liquids, crude oil and petrochemical pipelines and associated facilities. EPD has managed to increase annual distributions by 9.60% on average since 1999. The partnership’s units currently yield 9.80%.

Plains All American Pipeline (PAA) owns crude oil and refined products pipelines and associated facilities, primarily in Texas, California, Oklahoma, Louisiana and the Canadian Provinces of Alberta and Saskatchewan. Also involved in the marketing and storage of liquefied petroleum gas. PAA has managed to increase annual distributions by 7.40% on average since 1999. The partnership’s units currently yield 9.30%.

Energy Transfer Partners (ETP) owns natural gas pipelines and associated facilities. ETP also markets propane to retail customers in 40 states. ETP has managed to increase annual distributions by 13.50% on average since 1998. The partnership’s units currently yield 9.90%.
Oneok Partners (OKS) owns natural gas pipelines, processing plants and associated facilities, mostly in the Mid-Continent region. OKS has managed to increase annual distributions by 4.70% on average since 1994. The partnership’s units currently yield 10.20%.

As usual these MLPs are just a starting point for research and should not be taken as recommendations. Because of their unique structure, consult with a tax professional before investing in them.

Full Disclosure: Long KMR




This post appeared on Edition #197 of Carnival of Personal Finance

Relevant Articles:

- Best High Yield Dividend Stocks for 2009
- Kinder Morgan Energy Partners (KMP) Dividend Analysis
- TEPPCO Partners (TPP) Dividend Analysis
- No Risk Stock Market Investing
- Edition #197 of Carnival of Personal Finance