A MLP is by far the most unique investment we will look at in this series. It combines the tax benefits of a limited partnership with the liquidity of common stock. MLPs are a product of the U.S. Tax Reform Act of 1986 and the U.S. Revenue Act of 1987. These laws define which companies are eligible to structure their operations as MLPs. To qualify, a firm must earn 90% of its income through activities or interest and dividend payments relating to natural resources, such as petroleum and natural gas extraction and transportation. Certain real estate operations may also qualify as MLPs.
Like other limited partnerships, MLPs pay no income tax, instead the liability is passed to the unit holders (MLPs' name for shareholders). Instead of dividends, MLPs pay quarterly required distributions (QRD), based on the stated amount in the contract between the unit holders and the general partner. These distributions are not taxed when they are received. They are treated as a return of capital, thus reducing the cost basis of the investment. MLPs are extremely tax efficient.
However, this tax efficiency comes with a price. Once a year, each investor receives a K-1 statement providing details of the unit holder's share of the partnership's net income. K-1s can be quite large (I've had some up 30-40 pages) and complex for those without a tax background. Unit holders will record items such as their pro-rata share of the MLP's depreciation, state taxes, etc. on their individual tax form. In addition to the tax burden, MLPs require more bookkeeping to track their basis. Each year the share basis is adjusted down by the amount of cash distributions and also adjusted by the unit holders allocation of net income. Below are some popular MLPs:
Enterprise Products Partners LP (EPD) - Yield: 7.10%
EPD is an integrated provider of natural gas and natural gas liquids services, including processing, fractionation, storage, transportation and terminalling.
Suburban Propane Partners LP (SPH) - Yield: 7.83%
SPH markets propane gas and other refined fuels to residential, commercial, industrial, and agricultural customers.
Energy Transfer LP (ET) - Yield: 7.11%
Energy Transfer owns a large platform of crude oil, natural gas, and natural gas liquid assets primarily in Texas and the U.S. midcontinent region.
One way to avoid some of the tax headaches is to own MLPs via funds. The funds deal with the K-1s and issue 1099s to shareholders of the fund. This too comes with a price - the management fees of the MLP funds below:
Even if I could accept the high fees, there is one other item about MLPs that gives me pause. They are notoriously late in their tax reporting. It was usually well into February before the first K-1 shows up. Then I would normally get one or more corrected K-1s, sometimes as late as early April. MLPs provide excellent yields and are a tax efficient way to invest, but you must prepared to deal with their quirky characteristics.
Full Disclosure: No position in the aforementioned securities.
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