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Everything Dividend Investors Need to Know About MLPs

Master limited partnerships—or MLPs—have long been popular products for dividend investors. These securities are known for their juicy yields that bring in income investors of all disciplines. Below, we outline the ins and outs of MLPs and what you need to know in order to make a more informed investing decision:

What Exactly Is An MLP?

At their core, MLPs are businesses that produce, transport and store oil and gas resources. In order to help stimulate construction of domestic energy infrastructure, changes to the tax code back in 1986 allowed for pipeline firms to be structured as partnerships. Since then, the IRS has expanded that definition of what qualifies for MLP tax-status. Today, that characterization includes the exploration, mining, processing, refining or marketing of almost any mineral or natural resource.

Generally, MLPs are thought of as existing in the energy industry, as most of the largest companies with this structure deal in oil and gas. However, investors often forget that MLPs can exist in non-energy sectors as well, with a number of well-known companies with this structure producing timber, fertilizer, and others [see also 25 Ways To Invest In Crude Oil].

Being structured as a partnership certainly has its advantages for corporations and investors alike. First, MLPs are able avoid paying corporate taxes by passing on most of their free cash flow as tax-deferred distributions to investors since they are structured as partnerships. That’s huge for both private investors as well as the sponsoring firms – known as general partners or GPs.

For the general partners, that fact can be exploited in an advantageous way. Below is a table of some of the largest and most popular MLP stocks:

The Benefits to Using the Tax Structure

Aside from avoiding taxation issues, MLPs provide their GPs with juicy distribution payouts. After acquiring new pipelines, mines or gathering facilities, GPs will often pass along some of these prime assets into their MLPs subsidiaries. This process of dropping down assets allows the MLP to grow its distributable cash flow. These asset sales are often priced at a level that guarantees immediate cash flow accretion for the MLPs and then enables the MLPs to raise distributions at a faster rate. The general partner benefits directly from increased distributions on the limited partner units it owns as well as from increased incentive distributions — all while avoiding taxation on those assets [see also Guide To MLP ETFs].

Private and retail investors can also get in on the act. Income that MLPs distribute avoids the double taxation that corporate dividends suffer. Dividends that are paid out of earnings generally get taxed twice – once at the corporate level, then again as a taxable gain to shareholders. Perhaps more importantly, MLPs feature a further tax break, as a good portion of those high distributions qualify as tax-free return of capital rather than ordinary income. That allows taxes on 80% of MLP distributions to be deferred until investors sell their partnership shares; only 20% is immediately taxable as ordinary income.

All in all, that leads to some of the highest dividend rates available to investors, typically in the 5%-9% range.

Supporting those dividends is the stable nature of many of the industries that MLPs operate in. Pipeline and gathering firms’–the bulk of companies structured as MLPs–profits are based on the volume of oil or gas that flows through their pipes, not on what that liquid is worth. Many come with regulated fee amounts with inflation adjustments, as well as “take or pay” contracts, which require users to pay regardless of whether the capacity is used. This allows investors to profit from the long-term trend of increasing energy demand, while providing a backstop against price swings. While production-based MLPs–timber, coal and upstream oil and gas, among others–do see more fluctuations in their distributions, these firms feature long-life assets and generally stable production demand [see also The Beginner’s Guide to Timber Investment Funds: How to Invest in Timber].

On top of strong yields around the MLP sector, investors are concerned with performance; a high-yielding security does your portfolio little good if it constantly loses value. Luckily, MLPs have historically performed quite well, all while maintaining handsome dividends for their shareholders. The following chart shows a five year look at the Alerian MLP Index versus the S&P 500:

The Pesky K-1 & Other Nuances

As they say, “there’s no such thing as a free lunch.” The MLP world of high tax advantaged income does come with a few hassles come tax-reporting time. Instead of getting a standard 1099 form, MLP investors will receive a K-1 statement. This tax information typically arrives in investors’ mailboxes later than W-2s and other tax reporting sheets – usually between mid-February and early April. K-1 statements are also available on most MLP websites, accessible using your name and federal tax ID. Remember, MLPs are treated as partnerships and, as such, unit holders are treated for tax purposes as if they are directly earning the MLP’s income.

On the K-1, each unit holder is allocated his or her proportionate share of the MLP’s income, gain, deductions, losses and credits. Using the K-1, MLP owners are able to calculate their share of taxable income and they pay tax on it at their own tax rate. This tax is owed whether or not the unit holder receives a cash distribution. Additionally, unit holders may be required to file separate state income tax returns in each state in which an MLP operates. Remember, pipelines are mile and miles long, often crossing multiple state borders.

While this may seem complicated, the good news is that most qualified tax preparers are familiar with K-1 statements, and new updates to personal tax preparation software allow for investors to input these K-1s.

The following table, courtesy of the National Association of Publicly Traded Partnerships, shows an example a hypothetical MLP investment and the taxes incurred:

MLP Tax Example

Investors should also be aware of how MLP distributions are treated when packaged in mutual funds and ETFs. Depending on the structure of the fund, the tax burden and necessary forms can be quite different and sometimes less advantageous than owning the stocks outright. Click here to learn more about funds that hold MLPs and their tax treatment.

Finally, MLP investors should familiarize themselves with the concept of unrelated business taxable income or UBTI. UBTI as defined by the IRS is income not substantially related to an account’s or organization’s charitable purpose, educational purpose or other purpose. An investment in an MLP can be classified by many tax-exempt investors as “unrelated” to their day-to-day mission. If UBTI from all investment sources exceeds $1,000, these accounts may be subject to taxation. Your tax-exempt account (i.e. your IRA or 401(K)) could become subject to taxation. While smaller investors can get around these rules, it’s generally best to keep MLPs in a taxable brokerage account to avoid UBTI potential and profit from the security types other tax benefits.

The Bottom Line

While master limited partnerships can be confusing come tax time, the benefits of high current income and tax deferral outweigh these headaches. For those investors looking for income, MLPs offer one of the best opportunities out there to profit. I would just keep your CPA on speed-dial.

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