Confusion and misunderstanding provides opportunities for many who are willing to really make the effort to dig into the detail and learn the fundamentals of difficult topics. Such as a befuddled 7th grader whose eyes glaze over when the math teacher first broaches the topic of algebra, many investors shy away from Master Limited Partnerships because they do not fit standard for stock investments, have yields which are “excessive,” are not measured by the same metrics as other equities, may possibly not be befitting IRAs, and generally are “more difficult” to know than their other investments. However, for anyone willing to take some time to examine a little bit, they will realize that the planet of MLPs is not all that complicated and can provide a wonderful opportunity for a longterm steady and growing income.
To begin with, what’s a Master Limited Partnership? Master Limited Partnerships were established within the US Tax Code allow smaller investors to be involved in operations with very costly up front costs such as oil and gas pipelines that would be out of grab the typical investor without this type of partnership arrangement. Firms that choose to operate as MLPs are generally large, slow growing and stable and frequently have a monopoly within the territory which they operate. The assets generally produce a regular cash flow, but growth is slow and limited by purchases of like facilities or new construction. Master Limiter MLPs don’t pay any corporate taxes, (often yielding higher returns as a result), rather income goes directly to the machine holders pro rated by the amount of units they hold, and the machine holder is taxed at the individual’s tax rate. Each unit holder is really a limited partner whilst the operation of the business is handled by the typical partner.
Not every company can qualify being an MLP. First the business must earn 90% or maybe more of its income from natural resources (energy, mining, timber), minerals, commodities, real-estate, real-estate rents, or gains from dividends and interest. However, most MLPs currently are in the energy area, specifically in oil products pipelines and natural gas pipelines. Generally oil product pipeline MLPs receive regulated fees for the transportation of product and are paid on volume unrelated to the buying price of the product being transported. This helps make them more stable. Natural gas pipeline operators also frequently run the gas gathering work as well which provides them experience of the fluctuations in natural gas pricing. Many gas MLPs reduce the impact of price changes by hedging thereby establishing a more predictable cash flow.
MLPs make quarterly distributions which seem just like stock dividends however they are quite different. Typically a quarterly distribution is classified as partially net income, and partially a return of capital (in the planet of MLPs this return of capital is another name for depreciation or a depletion allowance). Generally, the Return of Capital represents the lion’s share of the distribution. The income percentage of the distribution is taxed at the individual’s normal tax rate whilst the return of capital segment reduces the fee basis. Which means you don’t pay any taxes on nearly all the distribution until such time as you sell the units. In a regular taxable account this makes MLPs suitable for both long term investors and people that plan on leaving their units for their heirs.
In an IRA, and other tax deferred accounts, there’s one additional complication. That’s, small segment of the distribution that’s treated as net income is classified as UBTI (Unrelated Business Taxable Income) and if this portion exceeds $1000 annually it is subject to income tax even yet in a tax deferred account, such as an IRA, forcing the IRA to file a tax return. This dilemma is non existent for the typical investor where the UBTI will generally fall below the $1000 barrier. For investors with hundreds of thousands of dollars invested in MLPs in their IRAs, UBTI can be a more important factor. For individuals who are unsure it is very important to find tax advice from the CPA and other tax specialist.
Evaluating an MLP is unique of evaluating an average stock. Because of the huge outlays in capital equipment, and resultant typically large depreciation expenses, the typical earnings metrics are not befitting evaluating an MLP. Distributable cash flow is the most important single aspect in evaluating whether an MLP is appropriate for you. It’s the origin for paying the quarterly distributions and provides cash for future expansion. It is very important to determine how consistent the distributable cash flow has been, and whether it has grown. For instance, Kinder Morgan Energy Partners, one of the best known MLPs paid $0.475 per quarter in 2001, and just recently announced so it is going to be paying $1.10 per quarter in 2010 up from $1.05 per quarter in 2009. It’s this sort of consistent growth in distributions which have made MLPs a favorite of the more sophisticated yield investor.