Friday, May 29, 2009

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

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