A Source of High Yields from the Energy Patch
For stock investors hungry for a high dividend income stream, there’s a powerful alternative that many investors have unfortunately ignored. It’s called a master limited partnership (MLP). You’ve probably heard of MLPs, but even seasoned investors harbor misconceptions about them.
Let’s examine the ins and outs of MLPs and how they can maximize your income.
MLPs generate predictable cash flows and pay a generous dividend — technically a “distribution.” Whereas income investments such as real estate investment trusts (REITs) specialize in real estate properties and yieldcos in renewable energies (such as solar and wind farms), most MLPs have a hand in America’s energy infrastructure.
In the 1980s, Congress limited the MLP structure to companies that generate at least 90% of their income from exploration, production or transportation of natural resources. As a result, most MLPs operate in the energy industry.
Furthermore, most energy MLPs occupy the midstream segment. This means they operate in the oil and gas gathering, processing, transportation, and storage businesses. They have benefited from the fracking boom over the past decade.
A Mix of Fixed and Variable Revenue
How an MLP makes money depends on its business model, but usually an MLP will have a mix of fee-based and non-fee based source of revenue.
Revenue from fee-based arrangements depends on how much oil, gas and other petroleum products are handled and processed through the MLP’s assets. Think of them like tolls.
This offers some protection against commodity price swings because the MLP’s fee-based revenue depends on volume, not commodity pricing. However, if energy prices stay depressed for a long time, activity will probably fall and all bets are off.
The non-fee based arrangements are usually either 1) percentage-of proceeds (POP) contracts or 2) keep-whole contracts. Under POP contracts, the MLP gets a specified cut from the sale of the products that goes through its network.
Under keep-whole contracts, producers give the MLP raw natural gas to process. The MLPs will extract and keep the natural gas liquids (NGL) to sell. But they also have to return the British Thermal Unit (BTU) equivalent of the NGL it took to the producers by buying gas. In the keep-whole situation, MLPs make the most money when NGL prices are high and gas prices are low. Under both arrangements, the MLP is exposed to price swings to the energy commodities, but the risk can be managed through hedging.
As you may have guessed, the more of an MLP’s revenue that comes from fee-based contracts, the steadier its cash flow generally is.
Besides their high yields, MLPs offer one big advantage compared to regular stocks.
Tax-Related Pros and Cons
When you buy units (shares) in an MLP, you become a limited partner. The MLP passes through its income and losses directly to you. As a result, you only get taxed on the distribution once at the individual level. Corporate shareholders in effect pay taxes twice, once on profits at the corporate level, then again on the dividend at the individual level.
Some investors, though, avoid MLPs because when it comes to taxation, MLPs can be a bit complicated.
Typically, most of the distribution is classified as return of capital and is tax-deferred. Instead of paying tax right away, you reduce the cost basis of your MLP by the amount of the return of capital.
When you sell your MLP units, your taxable gain will be higher. And if your cost basis gets reduced to zero (which only happens if you hold the MLP for a long time), then every distribution thereafter is taxable as long-term capital gain.
The cost basis will also be adjusted upward or downward by aspects such as your share of taxable partnership income and deductions like depreciation. Come tax time, the MLP will send you a Form K-1 that breaks down the numbers, but compared to paying taxes on regular stocks, it can be daunting to keep track of everything.
One additional benefit: if you pass away and your beneficiary inherits your MLPs, the cost basis is reset to the fair market value. This means they will not be taxed on the previous tax-deferred distribution.
The rest of the distribution is classified as ordinary income and taxed at your income tax rate.
Better Fit for Taxable Accounts
There’s another reason some investors avoid MLPs. When held in a tax-sheltered plan like an Individual Retirement Account (IRA), they could trigger a taxable event. The IRA’s share of an MLP’s income is treated as unrelated business taxable income (UBTI). Form K-1 will indicate how much UBTI you have incurred (if any) for the year.
You will get a K-1 from each MLP. If all the UBTI in your IRA add up to more than $1,000, then the amount above $1,000 is taxable at an escalating rate depending on how much taxable UBTI there is.
Unless an IRA has many units of MLPs, it will unlikely generate more than $1,000 in UBTI. Even if tax is triggered, the custodian that holds your IRA will pay the tax by deducting the money out of your account, so you don’t need to pay it directly. Still, the potential for tax is enough to scare some investors away.
Also, since an IRA is already tax-deferred, the MLP’s tax benefit is effectively wasted. To realize an MLP’s tax advantages, it’s best to put it in a taxable account.
If you think the tax-related issues are too messy, an alternative is to invest in an MLP exchange-traded fund (ETF), such as the benchmark Alerian MLP ETF (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. AMLP yields about 7%, though that comes with a 0.85% annual expense.
As I’ve just explained, high yields sometimes come with complications. But my colleague Amber Hestla, chief investment strategist at Profitable Trading, has found a way to generate enticing yields… on demand.
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