MLPs

According to the WSJ, MLPs are “mostly companies that own and operate pipelines, primarily for natural gas and oil. While MLPs trade like regular stocks, their corporate structure typically requires them to distribute most of their cash flow to shareholdings. Added to their attractiveness, they get favorable tax treatment.” MLPs earn money by handling or transferring a commodity; they are not affected by the price of the commodity but are affected by demand.

MLPs do not pay corporate taxes because they are structured as pass-through partnerships; each investor owns a “unit” of the partnership. A partnership can be classified as a MLP if ~ 90% of its cash flow comes from real estate, natural resources, and commodities (activities or interest in). Taxes are not paid on the vast bulk of distributions (at least until 100% of capital has been returned), but rather when the investor sells his/her unit. If investor’s cost basis falls to zero (which would likely take 18-25 years), all distributions thereafter become 100% taxable as ordinary income.

The Tax Reform Act of 1986 and the Revenue Act of 1987 define the modern MLP. Investors receive an annual K-1 statement, which is somewhat similar to a 1099-DIV form. Each investor distribution reduces his/her cost basis. This huge tax benefit is largely due to the depreciation the MLP is able to take on its assets. A report by Wachovia Securities states: “taxable income passed on to investors often is only 10-20% of the cash distribution, while the other 80-90% is deemed a return of capital and subtracted from the original cost basis of the initial investment.”

MLP Tax Example

For example, Alice invested in a MLP three years ago; she bought one unit (share) for $100. For each of the past three years, Alice received a cash distribution of $6 per unit per year (6% yield). Of the $6 distributed each year, $1.20 was taxable. After exactly three years, Alice sold her MLP unit for $103. Here are the tax ramifications:

[a] $1.20 per year taxable x 3 years = $3.60 of taxable ordinary income

[b] $4.80 per year received as return of capital x 3 years = $14.40

[c] $100 cost basis reduced to $85.60 ($100 - $14.40)

[d] $100 (of the $103 selling price) - $85.60 = $14.40 taxed as ordinary income

[e] $103 - $100 = $3 long-term capital gain

As you can see from the example above, the “tax-free” portion of Alice’s distributions are eventually taxed, but only when she sells her unit (depreciation recapture). Thus, a more accurate way to explain the taxation of a MLP is that most of the distributions received should be considered tax deferred (and will only be taxed as ordinary income when the investor sells his/her MLP unit). Whenever they are taxed, such distributions are not “qualified dividends” and are taxed as regular income. The MLP investor may also experience a long-term capital gain or loss, depending upon the selling price of the unit.

MLP Estate Planning Strategy

What is potentially very exciting about MLPs is their place in an estate plan. When the investor dies, his/her cost basis gets a step-up, effectively wiping out the previously deferred tax build-up. For example, Hank paid $100 for a MLP unit. During his 12 years of ownership, the MLP paid Hank $80 in “tax deferred” distributions and $16 of distributions that were taxed as ordinary income. Last week, Hank died, leaving everything to his brother, Otis. On the day of his death, the price per unit of the MLP was $120. Otis will now have a cost basis of $120 (the IRS will not be able to collect on the deferral amount). Hank’s estate has no tax liability for the MLP unit (except for modest taxes on the MLP distribution paid during the year of Hank’s death—but only on the ~ 20% representing ordinary income, just like previous years).

MLP Returns

According to an August 2013 WSJ article, “over the decade ending July 31, 2013, MLPs generated an average total return, or income plus price changes, of 16% annually; U.S. stocks overall (S&P 500) returned an annual average of 7.6%.”

Since June 2006, the Alerian MLP Index had a total return of 76.2% through June 29, 2013. For the 5-year period ending June 29, 2013, the index was up 71.6%. According to a July 2013 article by Max Chen, “the Alerian MLP index and the Cushing 30 MLP index have earned an annual return of 20.5% and 23.6%, respectively, compared to the S&P 500’s 4.5%.” Historically, MLPs have not moved in synch with the S&P 500 (source: WSJ).