Thanks to the Sun reader who called to suggest this topic. I’m happy to communicate about topics that are important to our readers, so keep the suggestions coming. Master Limited Partnerships are commonly referred to as MLPs. It is a corporate structure authorized by federal legislation, and allowed for businesses in certain industries primarily it the natural resources arena. Ninety percent of the MLP's revenue must come from qualifying sources, usually the production, processing, or transportation of products like oil, gasoline natural gas or coal.
Investors can invest in MLPs by buying units of ownership in a brokerage transaction just like a stock trade. Units are commonly traded on the New York Stock Exchange and the NASDAQ market.
Why invest in MLPs? Past performance shouldn't ever be the main reason to invest, but this market segment has proven to be one of the best performing asset classes over the last three, five and 10 year periods. Fundamentals of the move toward less dependence on foreign sources of energy bode well for the future growth of companies in the business of producing and transporting energy related natural resources from their point of extraction to the refining facilities or final distribution facilities. Unit prices of MLPs fluctuate in a similar manner to stocks and investors should understand the potential for volatility before investing.
Shareholders (technically known as "limited partners") receive an immediate reward of a reasonably high distribution rate, typically in the 5 to 7 percent range. This distribution represents the limited partner's share of the profits from operations and tends to be significantly tax deferred due to the pass-through of depreciation expense of the pipelines or production facilities. This current tax benefit is not a total avoidance of taxes however, as the cost basis of the limited partners units is reduced by the amount of the tax shelter, which means that the capital gains when units are ultimately sold will be higher. But, since long-term capital gains are generally taxed at lower than normal income rates, there is still a significant benefit.
In addition to the current income and tax benefits, over time the value of ownership units of MLPs has tended to rise over time similar to the values of good quality common stocks. One interesting aspect of the structure of MLPs is that the general partner's level of profit can only go up when the limited partner's level of distribution goes up. This is a unique feature which aligns the interests of the people running the day to day operation with the investors in the enterprise, like you and I.
One word of caution related to investing in MLPs inside IRAs or other tax qualified accounts. Income from MLPs inside these retirement accounts greater than $1,000 a year triggers a clause known as "unrelated business income" and you would have to pay taxes on the income even though it was produced in your tax-deferred retirement account.
A development in the last few years helps avoid unrelated business income. When MLPs are contained in a mutual fund or exchange traded fund there is no tax impact from the income inside IRAs, no mater how large the level of income is. Several mutual funds and exchange traded funds are now available for everyday investors, providing diversification, professional management, and the ability to invest inside of retirement accounts, all while enjoying the benefits of this unique asset class.
One last thought which is a word of caution. One reason MLPs have done really well in recent years has to do with the ultra-low interest rate environment we are in and the desire of investors to earn higher yields than available on government bonds and CDs. If and when interest rates rise to more normal levels, MLPs dividend yields may seem a bit less attractive compared to some other guaranteed investments, and could come under some price pressure. The flip-side to this is that over time, MLPs tend to raise their distribution rates, so unit holders can see their income go up over time, a benefit not generally associated with government bonds or CDs.
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.