Master Limited Partnerships, are the returns worth the complicated taxes?

So you are debt free and have built up your emergency fund : what now? First congratulate yourself on a great accomplishment. Now, it's time to start investing and as far as passive investments are concerned, full market funds with low fees are the way to go. However, depending on your risk tolerance, a small portion of your portfolio can be in alternative investments. One such option to consider is Master Limited Partnerships (MLPs).

MLPs are a hybrid between a partnership company and a regularly traded stock company. When you buy an MLP you buy units (instead of shares) and become a limited partner (instead of a shareholder). The Investopedia website has a more detailed definition here.

Why should I consider MLPs?

Alternative investments are usually used as a hedge to protect your portfolio in the event your main investments perform poorly.  MLPs are worthwhile to consider because even when the market is down they still pay out consistent distributions.

Know what you own, and know why you own it
— Peter Lynch

A majority of MLPs are in or related to energy and tend to have very good profit margins.  MLPs avoid paying taxes by distributing all profits to the partners of the MLP. There are additional rules that regulate how much money can be kept by the MLP for cash flow and corporate reinvestment, so distributions to the partners are higher than a traditional corporation's dividends. This means that they pay cash distributions on an order of 5-16% each year. Additionally, the cash distributions usually count as a return on capital, so taxes are deferred until the purchase price is recouped. In other words, you don't pay taxes on the distributions you receive each quarter, you pay taxes on distributions when you sell the MLP. You get tax-free growth on the distributions themselves. Reinvesting these cash distributions greatly increases the wealth of your investment over time.

Ah-hah! What's the catch?

If you are thinking this sounds too good to be true, you are (partially) correct. MLPs have complicated tax rules, an additional tax form, called a K-1, has to be dealt with. Because of the tax issues MLPs are generally not advised for personal IRA's and often not permitted in company 401K accounts. This is because in certain circumstances, even when held in a tax free account, they can generate taxable income from Unrelated Business Taxable Income (UBTI). My employer 401K forced the selling of all individual MLPs held in accounts in late 2015 due to this possibility. Also, the cash distributions are taxed as regular income once your cost basis reaches zero (purchase price minus all cash distributions received), so on the order of 30% depending upon your income level and what state you live in. This means that to maximize the tax savings you will need to periodically sell and repurchase the MLP. Dealing with the K-1 forms starts getting into "hire an accountant range" which may scare some people away.

When you sell an MLP you pay taxes on the sale price minus your cost basis. This is the same as a stock or mutual fund except that your cost basis is reduced by the cash distributions you received while holding the MLP (taxed as capitol gains). Lastly an MLP at the end of the day is just a company. Investing in an MLP exposes you to the same amount of risk as investing in a single company. MLPs are mostly energy related and prone to the energy boom/bust cycles. Owning stock in an individual MLP makes you a limited partner which opens you up to more liability than a regular shareholder (the law is a little grey in this area)[,] but it appears to be limited to the tax burden only.  In my research I have not been able to find any cases of someone being held responsible for an MLPs action, but you can read more about the liability issues on the Master Limited Partnerships Association (MLPA) website.

So is there a way to easily invest in MLP's?

Want the returns of an MLP and avoid the complicated tax rules? Well you are in luck there are two ways to invest in MLP's in a more diversified and investor friendly manner Exchange Traded Notes (ETN's) and Exchange Trade Funds (ETF's). Both types have advantages and drawbacks and opinions vary greatly which is better based on basically arbitrary criteria. There is a great article "The definitive guide to MLP ETFs and ETNs". I won't rehash the full paper but in summary:

  • MLP ETNs are essentially bonds that pay out like an MLP. You assume the credit risk of the issuer and presumably the energy sector risk[,] but there is actually no guarantee that the ETN issuer owns MLPs.
  • MLP ETFs are in reality C-corporations and like a regular C-corporation dividends are subject to double tax (the profit of the fund is taxed at corporate rates and then you pay taxes on dividends) so your income is somewhat lower than an individual MLP[,] but you receive regular dividends which are easier to handle come tax time. Also the dividends may still be classified as return on capital allowing you to defer the taxes on the dividends.

Both give good returns in the form of dividends/distributions.

Conclusion

Both MLP ETFs and ETNs provide good investment opportunity and depending upon your situation you will need to decide which option is best for you. For me I prefer the simplicity of the ETFs.

It is important to point out that since MLPs are mostly confined to the energy industry I recommend investing no more than 10% of your portfolio in MLPs.

Full disclosure: At the time of this writing I held positions in AMLP and KYN EFTs