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Things to Know About MLPs

By Scott Chan on January 22, 2018

Master Limited Partnerships, or MLPs, are publicly-traded limited partnerships. Due to its partnership structure, an MLP is not subject to federal or state taxation at the business level.

For example, if you invest in a common stock like IBM (NYSE: IBM), you actually get taxed twice. IBM has to pay income taxes to the government, which reduces your share of the company’s profits. Then when you receive dividends from IBM, you must pay income taxes on the dividend, too.

Tax Advantage and Attractive Yields

In the case of an MLP, a share in an MLP is called a “unit.” When you buy units in an MLP, you become a limited partner in the MLP. You pay taxes only on what you receive from the MLP. Also, it’s possible for a unitholder to write off some of the cash distribution as depreciation. This means you don’t have to pay taxes on all the cash distribution you receive.

Because of this tax advantage, the MLP structure became so popular that Congress had to pass a law to limit the MLP status to a certain type of business. By law, to quality as an MLP, a business must generate at least 90% of its income from “the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource.” This explains why most MLPs operate in the energy industry.

Investors invest in MLPs usually for their attractive high yields. Currently, on average MLPs yield about 7%. But beware of yields that look too good to be true. Yields above 10% are usually not sustainable and it’s not a good idea to hold onto such high yielders for very long. When the market expects an MLP to cut its dividend, the unit price falls.

In fact, in the last few years, as oil and gas prices fell, a number of high-profile MLPs have cut distributions and restructured to preserve cash.

 

Investor angst over these cuts and the general perception that MLPs’ distributions may not grow very much have caused MLPs to greatly lag the overall stock market even though oil prices have risen. The new tax law also reduced some of the tax advantage of MLPs had over corporations.

Quality MLPs Remain in Good Shape

Nevertheless, quality MLPs such as Enterprise Products Partners (NYSE: EPD) and Magellan Midstream (NYSE: MMP) have held the fort and continued to increase their distributions.

If oil prices can avoid pitfalls in 2018, it should spark greater investor interest in some of the underperforming energy-related equities like MLPs. At the very least, solid players like the ones named above should at least be able to keep their distribution levels steady.

Some Tax-Related Cons

Of course, MLPs have also caused tax-related headaches.

Normal dividends are reported on Form 1099-DIV, which are relatively simple to complete. However, when you own MLPs, you have to complete a Schedule K-1. You are responsible for reporting your share of income, losses, deductions and credits that the business reported. This can be complicated and time consuming. So if you normally filed your own taxes, owning MLPs could force you to hire an accountant.

Additionally, if the MLPs are held in the tax-sheltered account, some of the distributions can be classified as unrelated business taxable income (UBTI). And when the UBTI in a tax-sheltered account exceeds a certain level, it will trigger taxes. For this reason, it’s better to hold MLPs in taxable accounts.

But, this only comes into play if the UBTI in an account is more than $1,000 for the year, so for most retail investors, it’s not an issue.

Another thing to keep in mind: The cash MLPs distribute to you also lowers your cost basis, so when you sell in the future, you will likely have to pay more capital gains tax. But since the capital-gains tax rate is lower than the income-tax rate for most people, it’s still a favorable trade-off.

If you think the tax-related issues are too messy, an alternative is to invest in an MLP ETF, such as the Alerian MLP ETF (NYSE: AMLP). Doing this will give you exposure to MLPs while avoiding the complications mentioned above. The downside, though, is that you will be invested in good and bad MLPs. The advantages of owning select high-quality MLPs make it worth the extra work come tax time.


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