Mastering limited partnerships

The character has the choice between three green roads

For the last seven years, interest rate suppression by central banks worldwide has forced investors to reach for higher yielding investments. High cash payouts relative to the puny yields available on money funds and certificates of deposit have made Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs), High Yield bonds and dividend-paying stocks popular vehicles for retail investors. In this article, we examine some of the distinguishing characteristics of Master Limited Partnerships, as well as the pros and cons of using a pooled vehicle, such as a mutual fund or exchange traded fund (ETF), to gain exposure to MLPs. (This article is not a comprehensive review of MLPs, nor is it meant to provide tax advice. We urge you to seek advice from your tax advisor if you have specific tax questions.)

Unlike the vast majority of publicly traded companies, which are structured as C-corporations under the U.S. tax code, MLPs are structured as partnerships. This structure allows MLPs to avoid the “double taxation” of paying tax once at the corporate level, and then again at the shareholder level. Instead, MLPs pay no tax at the partnership level, and pass distributions through to limited partners. MLPs can be traded on public stock exchanges such as the New York and American stock exchanges, and NASDAQ.

These are the basics. There is nothing basic about the tax treatment of MLPs, however. What MLP investors gain in the form of lower taxes, they give back in terms of complexity. Tax treatment of MLPs varies, depending upon the types of investment accounts in which they’re held, the vehicle used to access the MLP and the tax status of the investor. One nuance for investors who choose to invest in individual MLPs (as opposed to  pooled accounts such as MLP funds) is that MLP owners receive K-1 forms at year end showing their share of the partnership’s income, gain, loss, deductions and credits.  Depending upon the number of MLPs held, this can create a significant burden when it comes to filing taxes. Additionally, some portion of MLP distributions can be considered a return of capital, which can lower the cost basis and defer taxes. Finally, MLPs can generate something called “unrelated business taxable income”, or UBTI, which is problematic for certain tax-exempt accounts, such as pensions, 401Ks, individual retirement accounts and endowments. All these (normally tax free) entities could be subject to tax on UBTI if they hold MLPs.

Over the past decade, as the hunger for yield amongst the investing public has grown, Wall Street has introduced numerous vehicles to both provide access to, and simplify, investing in MLPs. Some examples include Open-End Mutual Funds, Closed-End Mutual Funds, Exchange Traded Funds (ETF), Exchange Traded Notes (ETN), Hedge Funds, Separately Managed Accounts, and Insurance Dedicated Funds. One advantage to owning MLPs via these vehicles: the C-Corp structure effectively “blocks” the K-1s that investors in individual MLPs normally receive; investors in MLP funds instead receive a simple 1099 at the end of each year. This obviously eases the tax reporting burden, and this structure also makes them suitable for tax-exempt accounts otherwise subject to UBTI.

However, tax rules say that any fund with over 25 percent of its assets invested in MLPs must be treated as a C-Corporation. As a result, such funds must accrue corporate level taxes on the appreciation in their holdings. Corporate level taxation of MLP funds, currently 35 percent of both income and unrealized gains, thus effectively negates the tax benefits of MLPs. Most MLP fund investors don’t know this tax liability even exists, because it is reflected in the daily calculation of the fund’s net asset value (“NAV”). The result is a tax “drag” of 35 cents on every dollar earned. Interestingly, this tax drag works in both up and down markets, resulting in an investment that normally has less volatility than the market index—a good thing. But beware—a fund with an existing tax liability will be less volatile during a market decline until it reaches its ‘zero’ point—the point where it’s tax position switches from liability to asset. At that point, further NAV declines can actually become accentuated relative to the market. Such was the case for many energy MLPs this past September as result of ongoing oil price declines. It’s complicated, but suffice it to say that when investing in MLPs, it pays to know the tax history of any fund you’re considering.