The Benefits of Master Limited Partnerships
MLP's for the Average Investor
A Master Limited Partnership (MLP) is a partnership which has the ability to trade on a public securities exchange. There are two core components which are the Limited Partner and the General Partner. The Limited partner is the investor who puts up the capital. The General Partner is the one who manages the operations of the MLP, and is compensated via incentives to increase the cash flow of the MLP. Typically the General Partner would receive about 2% of the annual distribution. The tax code affords certain industries to organize as an MLP. Namely companies engaged in the energy sector such as petroleum and natural gas.
MLP’s demonstrate some degree of similarity to Real Estate Investment Trust’s (REIT’s) in that they are not subject to the double taxation. They avoid the corporate tax with distributions paid directly to the limited partners taxed only at the personal income tax level. Each year the limited partners/investors receive a K-1 detailing the tax liability of their annual distributions. These distributions are typically paid to the investors quarterly. Should the MLP fail to pay the quarterly dividend, it could constitute a default and jeopardize the MLP status. However, the quarterly distributions paid to the investors consist of a portion of repayment of principal which is received tax free. As an example, a $1 dividend paid at the end of the quarter may be compromised of .70 cents principal payment, which is tax free, and .30 cents of taxable income. The repayment of principal component thereby reduces the investor’s basis in the investment. In such an example, if the initial investment was $10 per share in the MLP, the new basis would be reduced to $9.70 per share at the end of the quarter. This has the effect of essentially deferring tax liability for the duration of the period the position is held. In the event that a position is held long enough that all of the distributions have reduced the investors cost basis to zero, then the future quarterly dividends would be 100% taxable to the investor.
Prior to 2004 mutual funds were restricted from the ability to own an MLP, hence making it largely unavailable for the average investor. Even after this restriction was lifted, they were still held in limited circulation among the average investor due to the tax problems presented in holding these positions in retirement accounts. The inherit tax deferral of the IRA negates the tax benefits of holding an MLP in a retirement account. Additionally, the MLP holding can be subject to the Unrelated Business Taxable Income (UBTI) when held in an IRA. However, recently a number of funds have been launched as traditional mutual funds as well as Exchange Traded Funds and ETN’s that circumvent this problem. As an example an ETF compromised of a series of MLP’s can be classified as an investment fund under the Investment Company Act of 1940. (Also known as a 40 Act Fund) This avoids the K-1 reporting and the potential for problems arising from the UBTI tax, and allowing these positions to be eligible for placement in a 401k/IRA or other tax deferred accounts. However, the 40 act fund status then subjects the holding to be taxed as a corporation for Federal Income Tax purposes. As such, the fund’s shares are further reduced by the accrual of any deferred tax liabilities rather than altering the shareholders basis directly. The taxable portion of the quarterly dividend may then be eligible for "qualified dividend" status and potentially reducing the tax liability further. Additionally, holding a series of MLP’s via a mutual fund or ETF can offer the aspect of diversity that is necessary while investing in any asset class.
Yet if the tax benefits of the tax deferral related to an MLP are redundant with the tax deferral in a retirement account, what would be the benefit of holding such a position in a retirement account ??? The answer is unrelated to tax treatment and more of a focus on pure investment returns and asset allocation. The recent returns of the MLP market have been strong over the last two decades. Even more importantly, the correlation between the MLP market indices to the broad market indices such as the S&P 500 have been relatively low when compared to other asset classes in the equity markets. Over the last decade ending in 2012, the Alerian MLP Infrastructure Index has correlated with the S&P 500 only 0.48% of the time while producing total returns in excess of the S&P 500. While continued outperformance of the S&P 500 is by NO means a certainty, the likely reduced correlation is helpful in maintaining a proper asset allocation and reducing overall portfolio volatility.
The risks of investing in MLP’s are not unlike any other investment. If you invest directly into one MLP, you may have simply selected the wrong one which is run poorly. It may also not have the liquidity that you desire. More importantly, due to the restrictions on which industries have business entities that can be organized as an MLP, any investment into this arena is inherently a concentration into a specific sector. In general sector investing is a form of market timing, which is a historically insurmountable task in the context of long term financial planning. So the placement of MLP’s or MLP funds into a long term investment portfolio should be limited as tool to reduce the correlation in the portfolio, while potentially offering tax benefits. The percentage exposure would be client specific. Yet in general, the average investor’s holdings should likely not exceed 5% of their total equity holdings.
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