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Wed. Mar. 31, 2010

Increasing Dividend Yield Part V: MLPs *

This is the fifth installment in a multi-part series that looks at various options used by income investors to boost their yield while waiting for dividend growth to lift their portfolio’s overall yield-on-cost. Last week we looked at Bonds. This week we are looking at Master Limited Partnerships (MLPs).

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 MLPs that have a history of increasing their unit distributions each year:

Enterprise Products Partners LP (EPD) – Yield: 6.60%
EPD is an integrated provider of natural gas and natural gas liquids services, including processing, fractionation, storage, transportation and terminalling. Years of distribution growth: 11

TC PipeLines LP (TCLP) – Yield: 7.80%
TCLP has interests in three interstate natural gas pipelines, including a 46.5% stake in Great Lakes Gas Transmission LP. Years of distribution growth: 11

Suburban Propane Partners LP (SPH) – Yield: 7.10%
SPH markets propane gas and other refined fuels to residential, commercial, industrial, and agricultural customers. Years of distribution growth: 11

Buckeye Partners LP (BPL) – Yield: 6.40%
BPL is one of the largest independent U.S. pipeline common carriers of refined petroleum products, with over 5,400 miles of pipeline. Years of distribution growth: 15

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. Note the management fees of the MLP funds below:

Fiduciary-Claymore MLP Opportunity (FMO) – Yield 7.01%
Fiduciary/Claymore MLP Opportunity Fund is a closed ended equity mutual fund launched by Claymore Securities, Inc. It is co-managed by Claymore Advisors, LLC and Fiduciary Asset Management, LLC.
- Total Assets: $444.3 million
- Expense Ratio: 2.92%

Tortoise Energy Capital Corporation (TYY) – Yield: 6.43%
Tortoise Energy Capital Corp. is a close-ended equity mutual fund launched and managed by Tortoise Capital Advisors L.L.C. It invests in the public equity markets of the United States.
- Total Assets: $22.6 million
- Expense Ratio: 3.92%

Tortoise North American Energy Corporation (TYN) – Yield: 6.30%
Tortoise North American Energy Corporation is a close-ended equity mutual fund launched and advised by Tortoise Capital Advisors, L.L.C. The fund primarily invests in the public equity markets of North America.
- Total Assets: $148.9 billion
- Expense Ratio: 3.21%

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. See a list of all my income holdings here.

(Photo: Steve Woods)


11 Responses to “Increasing Dividend Yield Part V: MLPs *”

  1. arbles says:

    It seems to me that MLPs would be very good (or even ideal) for an IRA (or even a 401k). I’m seriously thinking of moving some of my SEP IRA into an MLP. Would it, indeed, remove the tax reporting issues you mentioned if the MLP were owned as part of an IRA (including a Roth)?

  2. Rellif says:

    Works well in an IRA

  3. D4L says:

    arbles: I am not a tax expert (far from it), but my understanding is that certain investments that receive preferential tax treatment are immediately taxed in an IRA if the earnings reach a certain level ($1,000?). Check with your tax professional before investing.

    Best Wishes,
    D4L

  4. arbles says:

    Checking with a “tax professional”: that is what scares me about MLPs.

    1. I don’t have one, and if I did, then I would need them only for this one issue.

    2. In reading about them elsewhere, one individual commented that he had asked his tax preparer about them, and the response was that if the investor put money into them, then the tax preparer would be charging more money (and the hint was it would be a lot more).

    After I had asked my question above, I found one article about MLPs that came out and stated that they would NOT be a good idea for an IRA. They didn’t go into any detail but to suggest that it had something to with MLPs already avoiding some taxes. That doesn’t make sense to me. The worst it should be is neutral (i.e. no benefit at all for the MLP units to be owned by the IRA).

    I guess I could try it on a small scale for a year or two and see what the tax implications (both $$ and forms to be filed) are in owning.

    Thanks for the good article and the response.

  5. Ross says:

    I have 3 MLPs in my rollover IRA. My last K-1 comes in on March 19. I’ve done my taxes twice on TurboTax which shows you what info it needs…I looked at the form only after TurboTax filled it out.

    Apparently MLP income IS taxable even in a 401k,IRA etc. But only if the total income from all your MLPs is more than $1500. I think I Googled “tax MLP IRA” and came to the above conclusion after an hour or so.

  6. harold says:

    Man avoid mlp’s where possible expecially in ira”s.If you want to invest in MLP’s do it with something like the fmo closed end fund and etf’s. They are a bookkeeping nightmare.

  7. vr says:

    I did invest in one MLP last year and I wouldn’t do it again despite about 65% profit (dividends plus share price growth). K-1 is not for average Joe. TurboTax automatically took my numbers but after verifying the forms it appears that not all of them filled correctly. I had to twist TurboTax a bit to make it as it should. And I am still confused about 5 states where I have to file non-resident forms.

  8. D4L says:

    vr: I am where you are. I can’t justify the hassles given the amount of work required. I don’t think most investors are properly handling the multiple state taxes associated with investing in MLPs.

    Best Wishes,
    D4L

  9. George says:

    “Apparently MLP income IS taxable even in a 401k,IRA etc. But only if the total income from all your MLPs is more than $1500.”

    It’s UBTI (unrelated business income) that gets you in trouble with MLPs in an IRA. You could have unlimited income from an MLP provided the UBTI doesn’t exceed the threshold (my memory says $1k, but who trusts their memory?)

    If you trade MLPs, like I seem to do, the accounting gets even worse for tax basis. Using an ETF certainly is an attractive alternative…

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