MLPs are limited partnerships that are publicly traded. They are generally in the energy infrastructure industry. They have high income yields and preferential tax treatment, but they increase income tax complexity and require a Schedule K-1. They are generally only suitable for taxable accounts as partnership income generated in a tax-exempt account (like an IRA) can result in Unrelated Business Taxable Income (UBTI).
The tax advantage of MLPs is that the distribution received is treated as a tax-free return of capital in the year received. It would be more correct to say that the income is tax-deferred. The shareholders of MLPs are limited partners who are allowed to deduct depreciation expenses. The depreciation may offset up to the full amount of the income, resulting in 0% income tax in the year received. Depreciation that exceeds income is treated as a passive activity loss held until you have taxable income from the same partnership or depart the partnership.
The cost basis in the MLP is reduced by the amount of the distribution. When you sell the MLP, you are subject to recapture of the previous depreciation deductions. This recapture will be taxed at ordinary income rates. Any additional appreciation of the MLP will be taxed at the capital gains rate.
MLPs are generally not good options for charitable donation due to the depreciation recapture. Unlike donating appreciated common stock at fair market value, your deduction on a MLP is limited to only the appreciation over what you paid for the shares and not the adjusted cost basis. For example, if you bought shares of a MLP for $10,000 and donated shares with a fair market value of $15,000, your charitable deduction is only $5,000. If you substituted common stock shares in the example instead, your deduction could be $15,000.
Income Tax Complexity
There is more record keeping requirements with a MLP compared to a common stock. This includes the original cost, adjusted basis, and passive losses. They can even require additional state income tax filing requirements as MLPs often have assets, like pipelines, throughout several states. The Schedule K-1 is usually not available until around April or possibly later resulting in a possible need to file an extension on your federal returns. There are likely additional tax preparation costs involved with K-1s. It’s best to check with your CPA about these issues before purchasing a MLP.
The proliferation of shale energy production is one of the most important economic events in recent history for the U.S. Sites such as the Bakken, Eagle Ford, Marcellus, Haynesville, and Barnett are located in several states around the country. This has resulted in an energy boom that has increased onshore energy production by 48% in the past two years*. Master Limited Partnerships have benefitted from the increased infrastructure need and the current low interest rate environment.
Higher interest rates could impact MLP returns as some investors have used them as bond proxies and may move money back to bonds if real yields increase. This does not change the fundamental demand for energy infrastructure; however, so the long-term outlook for this asset is still positive.
A study by Ned Davis Research focused on finding the factors which predict larger future distribution growth which in turn historically has led to increased returns in MLPs. Their work showed that owning MLPs with high coverage ratios, high cash flow growth, and low leverage resulted in better returns. They have also noted the importance of assessing the general partner Incentive Distribution Rights (IDRs) and the impact those fees have on MLPs returns.
We caution investors that have used MLPs as bond proxies against this practice as MLPs have far more economic, operational, and political risk. However, we believe that this asset class will continue to experience secular growth and maintain attractive yields. The information obtained from Ned Davis Research in screening MLPs is quite useful in assessing candidates for further analysis. We also take into consideration geographic exposure and quality of management in our assessment along with other characteristics. We remain a long-term buyer of select MLPs.
The firm exited all MLP exposure on 11/28/2014. The large decline in the price of crude oil and decrease in the number of active rigs has severely impacted this industry. Debt issues from financing the infrastructure are a concern as well. We still think this industry has some attractive long-term potential, but we are waiting for better fundamentals before we invest in MLPs again. Assessing the financial strength, geographic exposure, regional production costs, and other factors will be important to consider before we enter this industry again.
*Ned Davis Research “MLP – Bond Bear Survival Guide” October 31, 2013
All investment decisions should be based on your specific situation. Please speak with your financial advisor before considering any changes to your investment portfolio. The information we have provided is for informational purposes only and is not intended to represent specific advice to anyone. We are not guaranteeing the accuracy of any information contained in this report and will not be held responsible for any errors or damages that result from acting on information in this document.