Masterful Income With Master Limited Partnerships

Published on Friday, 02 March 2012 21:13 Written by Todd Shriber

Imagine if you could get some serious tax breaks and exposure to the energy sector in a security that trades just like a stock. One option would be a royalty trust, but an even better option may be master limited partnerships, which we will discuss here today. Master limited partnerships are investments that have the liquidity of a stock, but get the tax treatment of a limited partnership. For the uninitiated, that means when you own shares of an MLP, you get a K-1 document that details your tax benefits and obligations.

Tax jurisdiction for MLPs is detailed in the Tax Reform Act of 1986, but we won't bog you down with a bunch of IRS lingo. Simply put, MLPs get a tax treatment that is similar to those of real estate investment trusts (REITs) or royalty trusts because MLPs distribute a large share of their net income to shareholders, and to be considered an MLP, the partnership must earn at least 90% of its income through businesses related to commodities, natural resources or real estate. Let's take a more detailed look at how MLPs work and see if they're right for your portfolio.

Where To Find MLPs

As we noted above, the energy and natural resource sectors are the ideal places to find MLPs. One that you may already be familiar with is Kinder Morgan Energy Partners L.P. (NYSE: KMP), the operator of gas and oil pipelines. While the energy sector is a great place to find MLPs, it doesn't need to be your only stop. Private equity giants Blackstone Group (NYSE: BX) and Fortress Investment Group (NYSE: FIG) are also structured as MLPs.

Still, most MLPs are found in the energy patch because they are required to pay quarterly required distributions (QRDs) to shareholders and the pipeline business, while not sexy, usually produces consistent, predictable earnings.

Tax Breaks Galore

The tax benefits of owning MLPs are hard to beat. There is no tax for the MLP owner at the corporate level and this frees up more cash to expand the business and to pay shareholders. This help MLPs avoid double taxation of dividends. At the end of the day, it's a lot cheaper to be an MLP than a regular incorporated company.

The MLPs tax liability is passed on to shareholders, also known as unitholders. The tax burden for unitholders isn't all that bad with energy-related MLPs because deductions for depreciation of assets can be made, as is the case with royalty trusts. The bottom for MLP unitholders is that they can expect to pay taxes on 10% to 20% of the distributed cash they receive because the other 80% or 90% is considered capital returns and taken away from the cost of the initial investment.

Essentially, your tax obligations with MLPs are deferred until you liquidate your investment, but if your cost basis falls to zero, you will be taxed on cash distributions from that point forward. Consult your accountant or financial planner if you questions about the tax treatment of MLPs.

Becoming An MLP Unit holder

MLPs are definitely solid investments and the tax benefits are something most investors should consider, but for as attractive as this asset class is, you'll likely need to acquire MLP units on your own. What we mean is that due to the tax benefits MLPs get and the K-1 documents that unit holders must receive, mutual funds, pension funds, IRAs and 401-k's don't own MLPs. Either their structure forbids them from doing so or they don't want to deal with the paperwork. Either way, if you don't want to miss out on the benefits MLPs, you'll need to make the investment on your own.