Master limited partnerships, or MLPs, represent an attractive investment opportunity, as they provide tax-advantaged assets with lofty dividends and buoyant prospects for growth.
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MLPs trade on exchanges like stocks do, though investors buy units of partnership rather than stock shares.
Because MLPs are limited partnerships, they don't face double taxation. MLPs are subject to no taxes at the corporate level. Most companies, by contrast, are obligated to pay corporate income taxes. And after that, shareholders pay taxes on the dividends they receive as well.
MLPs are required by law to provide a quarterly distribution. In October, the yields for many MLPs stood higher than 6%. Other investments that offer both income and safety generally don't yield that much.
"For income investors looking for something that beats Treasuries, corporate bonds, utilities and REITs (real estate investment trusts), I think MLPs win hands down," says Jason Stevens, an MLP analyst for Morningstar, a Chicago-based investment research firm.
Most MLPs are involved with the transportation, storage and distribution of energy products, with natural gas pipelines making up most of the asset class. That's where safety enters the equation, as the pipeline owners generally have long-term contracts providing them fees for transporting the gas.
"The pipeline is like a giant toll road -- think of it as a turnpike," says Bob Payne, managing director of Payne Capital Management, a financial advisory firm in Blue Bell, Pa.
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So MLPs generally boast a healthy balance sheet and steady cash flows.
The tax advantage
The tax accounting for MLPs' quarterly distributions is quite favorable. In most cases, only 10% to 20% of the distribution counts as net income. So shareholders would pay their regular income tax rate on this portion.
The rest of the distribution is considered a return of capital. So this portion isn't subject to tax. Rather it is taken out of the holder's cost basis.
Long-term MLP investors may see their cost basis ultimately drop to zero. When that happens, all distributions are subject to tax, though in many cases it's a capital gains tax rather than a regular income tax.
That makes quite a difference, as the long-term capital gains tax rate tops out at 15% through 2012, while the top income tax rate totals 35%.
"The key advantage of MLPs is that they offer a highly tax-shielded distribution that has a pretty good track record of growing 4% to 8% a year," Stevens says. "When you have 6% to 7% yields growing at that level, you're enjoying a total return that beats out most investments in this market environment."
While demand for natural gas does ebb and flow, its use is so ubiquitous that consumption will keep rising, experts say. "As long as we continue to heat our houses and turn on the lights, the volume of natural gas won't disappoint," Stevens says.
K-1s & IRAs
MLPs turn more difficult when it comes to figuring out your taxes. You have to fill out a K-1 form rather than the simpler 1099 form. And making matters more difficult, sometimes holders have to fill out K-1 forms for each state in which the MLP does business.
"A K-1 from an oil or gas investment can be quite complicated," says Richard Rampell, CEO of Rampell & Rampell accounting firm in Palm Beach, Fla. If you have an accountant, it will generally cost you $100 to $500 for each K-1, he says.
Also, don't think of MLPs as an investment for your retirement account. And why is that? First, since much of the income you receive from an MLP is tax-deferred to begin with, there's no need to put it in a retirement account.
In addition, if you hold MLPs in an Individual Retirement Account, or IRA, you may have to pay a tax on unrelated business taxable income, or UBTI. You can face tax payments on UBTI for income of more than $1,000 per year, even though that income is generated within a tax-advantaged retirement account.
ETFs & ETNs
You can eliminate the K-1 issue by purchasing an exchange-traded fund, or ETF, or an exchange-traded note, or ETN. Both of these represent a basket of MLPs. The distributions are treated as regular dividends for tax purposes. And you can hold these investments tax-free in your IRA account.
But beware that the fees charged by the ETFs and ETNs -- generally 75 to 200 basis points -- will subtract from your dividend. And if you buy an ETN, you face a risk that the note's issuer, a bank or securities firm, may be unable to pay back the note in a time of crisis.
As for choosing MLPs, if you don't go the ETF or ETN route, experts recommend buying at least three or four different ones to provide diversity. To make sure an MLP's distribution is safe, look for those whose distributable cash flow totals at least 1.1 times the payout, Stevens says.
While distributable cash flow isn't part of MLPs' official financial statements, it is usually included in their earnings press releases on the Internet.
Payne recommends larger MLPs for their competitive advantages and solid capital structures. "Go with the best in breed," he says.