Wednesday, November 12, 2008

Master Limited Partnerships

I've been promising an overview of Master Limited Partnerships (MLPs) and here it is, for what it's worth. Going into this I had little idea of how complicated MLPs are compared with ordinary dividend paying stocks. Sure, MLPs trade just like stocks, but their characteristics--especially when it comes to taxes--are vastly different. It would behoove you to at least be aware of them before you doing any investing in this area.

What is an MLP?
MLPs have exactly the same liquid trading characteristics as stocks, but they are very different from them. MLPs are structured as limited partnerships: the general partner is the company that runs the operations and the limited partners are the share holders, called unit holders, who share in the profits. (Note: An “L P” after a company name means limited partnership and is most likely an MLP, if in the energy space.) MLPs are what is known as “pass-through” entities, meaning that income generated from operations is not taxed on the corporate level. Rather, the entire dividend (called a distribution) is “passed-through” to the unit holders who are ultimately responsible for paying the taxes. But don't let that dissuade you because in most cases asset depreciation can offset the majority (usually 80-90%) of the tax liability. Because the distribution is not doubly taxed allows for a higher distribution amount which is good for the unit holders.

Types of MLPs
Most MLPs are engaged in oil and gas businesses (including propane) involving distribution (via pipeline), storage, and retailing. There are a few MLPs involved in coal (which could be a hot commodity if President-elect Obama has his way), one involved in amusement parks (FUN). and another involved with cemeteries (STON)! Don't laugh--the last one could have a bright future what with the aging of the baby boomers.

Tax consequences
MLPs maximize their tax advantages by owning long-term depreciating assets such as pipelines. Unit holders can offset their distributions by the rate of depreciation (also called the rate of deferral—typically on the order of 80-90%) and pay taxes on the remaining 10-20% at ordinary income tax rates. The balance of the tax isn't owed until the security is sold or until the total distribution income exceeds the cost basis. This is why this investment is great for those with long investment horizons.

It's also a good one for estate planning. If the owner of the security dies, the reduced cost basis is stepped up to the current share price thus eliminating any current tax liability.

MLPs that operate in more than one state (and most do) will have tax consequences in most of them. Each state has a certain specified threshold above which you'll be required to pay taxes. This can be a real drag come tax time. My recommendation with all of the above is that unless you're a tax-filing ace, have a professional tax preparer help you with MLPs.

MLPs in IRAs
Holding an MLP in an IRA is not unwise, but it is complicated. If you receive MLP distributions totaling more than $1000 in a year, you might be taxed on it (yes, even in an IRA!) depending on how much of that distribution can be considered to be unrelated business income (UBTI). You can find out the amount subject to UBTI by looking at your K-1 statements. On line 20: Other Information, UBTI is coded by the letter “V”. If you have more than one MLP, add up all of the UBTIs. (Note: The UBTI can be a negative number.) If the total is a positive number, you'll owe taxes on that amount.

Why buy MLPs now?
MLPs are an attractive vehicle especially for those of you with longer investment horizons because of their relatively high distribution rate. Plus, you're getting a steady double-digit (in most cases) rate of return which is nothing to sneer at. In a recent article, Jim Jubak feels that natural gas is the short-term winner from the utility cash crunch, saying that when the economy finally turns around demand for electricity will skyrocket forcing utilities to turn to natural gas as the only quick fix. He goes on to say that lowering interest rates will put upward pressure on high dividend paying stocks and MLPs which will be more attractive investments than low-paying treasury notes.

What to look for when shopping for an MLP
1. A high tax basis which is the level at which you can depreciate assets. You want this as high as possible, at least 80%. To keep this rate high, a company needs to either make new acquisitions or construct new pipelines or facilities. You can read about a company's expansion plans in its quarterly and annual reports in the management summary as well is in the Summary section found in the SEC 10-Q and 10-K reports (www.sec.gov).

2. A company with a strong distribution growth history. Most, if not all, MLPs pay their distributions quarterly. One place to check their distribution growth pattern is at Yahoo! Finance. Just enter the stock symbol, click on Historical Prices, and select Dividends Only. It's that easy.

3. Some MLPs offer tremendous incentives to its managers (e.g., the general partners) if they can meet certain distribution pay out levels. These incentives should be listed in the company's annual report.

4. A large, established player in the field. High construction costs coupled with demanding government regulations makes entry into this field difficult. MLPs with large asset bases and widespread operations hold a definite advantage over the smaller players.

5. You also want to check the balance sheet to make sure that the company is not loaded up with short term debt.

MLP risks
The article cited below from Personal Investment Notes gave the best discussion of MLP risks:
“The pipeline MLPs are considered more conservative and are characterized by stable cash flow and slow growth. Propane distributors are more aggressive investments than pipelines. The propane industry is a non-regulated, seasonal, slow-growth industry with moderate exposure to commodity prices. Coal MLPs also have moderate exposure to commodity price volatility. However, their principal end-user customers are public utilities, thus, overall risk is considered relatively low. The riskiest are the E&P MLPs [oil and gas exploration and production].

Generally, the MLP distribution is not guaranteed. Most MLPs (like corporations) have restrictive debt covenants, which can impair distribution payments if a default occurs.”

Summary
There's a lot here to know but I hope I haven't dissuaded from adding a couple of these to your portfolio. After all, if they're good enough for Jim Jubak, Jim Cramer, and Mark Cuban, they're certainly worth a look.

Tomorrow, we'll take a technical look at the MLP field and I'll toss in my recommendations.

References
Master Limited Partnerships. Personal Investment Notes. 5/16/08
http://invest.smartlabsoftware.com/archives/7

Should you follow Buffett this time?, Jim Jubak on MSN MoneyCentral, 11/11/08.
http://articles.moneycentral.msn.com/Investing/JubaksJournal/should-you-follow-buffett-this-time.aspx

1 comment:

Fritz said...

I'm grateful for the insight about IRAs and taxes. I still have one question, "Can MLP units be optioned?"