From the February 9, 2011 issue
Master Limited Partnerships, fondly known as MLPs, have become popular in recent years primarily for their relatively high level of dividend payments and some tax benefits. We'll review some of the pros and cons of this form of equity ownership, including the type of account you should own them in, and some other things to watch out for.
Similar to owning a stock, ownership of MLP "units" represents an equity type position in an operating company. The difference between owning "units" in a partnership and "shares" in a corporation may appear minor at first, but on examination can create some distinct advantages or disadvantages depending on your perspective.
First, MLPs don't pay tax at the corporate level due to IRS regulations that allow for passing the income to the unit-holders as long as the MLP generates more than 90 percent of its income from "qualified sources," generally being the production, processing, or transmission of energy products. Consequently, virtually all MLPs are in energy related businesses. This is a big advantage compared to the typical corporate structure where profits are taxed at the corporate level, and then taxed again as income paid to shareholders in the form of a dividend.
Second, the income passed through to the unit-holder is classified as a "distribution" as opposed to a "dividend." Distributions may be partially offset, sometimes significantly, by depreciation expenses of the MLP, meaning that the amount of the distribution may be only partially taxable in the years when it is received.
However, this sheltering of current income is not a totally free lunch. The portions sheltered by depreciation expenses reduce the unit-holder's cost basis in their ownership of the MLP, meaning that when the MLP units are sold, you will have a larger capital gains tax liability. Still, the delay of payment of the tax to the point of sale, and the payment of long-term capital gains tax compared to ordinary income tax may be preferable to many investors.
MLPs have traditionally paid very generous levels of distributions. Typically these have run in the annualized yield range of 6 to 8 percent. Recent popularity of these vehicles in the low interest rate environment we have experienced has driven MLP unit prices up and yields down to where the higher quality MLPs are providing current yields in the 5 – 6 percent range.
So far, it may sound like MLPs are the only thing you need to own considering all the advantages highlighted above. Not so fast though. As usual there is not one perfect investment and the characteristics which create advantages in one respect, usually create disadvantages in another.
For example – sounds like MLPs may be the perfect investment for an IRA to provide cash flow in retirement. Again, not so fast. If you own enough MLPs in your IRA to generate over $1,000 of income per year, your IRA custodian is required to file Form 990T with the IRS, and the income over $1,000 is considered taxable income even though the asset was held inside an IRA. This type of income is known as URBI, or un-related business income.
One potential way around this IRA – URBI problem is to own an ETN (Exchange Traded Note) which specializes in MLPs inside your IRA. By "wrapping" the individual MLPs inside the ETN, you can avoid the URBI problem and also get a diverse selection of MLPs in one easy purchase. Several ETNs have been issued in the last year or so with UBS securities being the largest issuer thus far. (This mention is not an endorsement nor recommendation of the ETN's from any firm).
Another issue at the moment is valuations. When I see asset categories being priced dearly, forcing yields to historic lows as identified above, I like to ask the question of whether the asset class has become too popular. No financial trend lasts forever, and I suspect the returns in MLPs may be sub-par over the next few years, probably restricted to the distribution yield alone. But, that's just an opinion.
Summary – MLPs may provide generous income streams with some tax advantages for the long-term investor in non-qualified (non-retirement) accounts, but prices appear elevated at present. Patience may provide a better time to establish new positions in the next year or two.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.