By Peter Mastrantuono
One popular income solution in a low interest rate environment has been Master Limited Partnerships. If investors think, however, that Master Limited Partnerships (MLPs) are a bond alternative, they may be in store for an unpleasant surprise.
What is an MLP?
MLPs are publicly listed limited partnerships that were created by Congress in the 1980s as an alternative means to raise capital. The majority of MLPs have general partners who manage the day-to-day operations and limited partners, i.e., the investors who receive the MLP’s earnings in exchange for the capital provided.
MLPs are very different from the traditional corporation. For instance, MLPs are not taxable at the entity level; instead all the accounting occurs at the investor level. Limited partners receive an annual K-1 form to help them properly report earnings to the IRS.
This pass-through feature provides a valuable benefit to investors by subjecting earnings to taxes only once, as opposed to corporations where earnings are taxed twice—as corporate earnings and the second time to the shareholder when earnings are distributed in the form of dividends.
Advantages and Disadvantages of MLPs
There are a number of key advantages and disadvantages to MLPs of which investors should be aware prior to investing.
Advantages
- Tax benefits: Some or all of an MLP’s distributions may be a tax-deferred return of capital, which means that investors are not subject to taxes until such time they sell their interest in the MLP. Moreover, MLPs may also qualify for the 20% earnings exclusion from income tax available to pass-through businesses.
- High yields: Due to the nature of the investments made by MLPs and their pass-through structure, investors typically receive a higher yield than they would receive on common stocks or bonds.
- Liquidity: As publicly traded units, MLPs offer much greater liquidity to investors compare to traditional partnership investments.
Disadvantages
- Highly volatile: Since most MLPs are invested in natural resources related sectors (e.g., oil exploration, natural gas, pipelines) the value of an MLP may swing widely, adding a degree of risk with which many income-oriented investors may be uncomfortable. Rising rates may make MLPs less attractive relative to common stocks.
- Subject to UBTI: MLPs may subject investors to Unrelated Business Taxable Income that could be taxable, even within an IRA.
- Limited market: The MLP structure can make them unsuitable for certain institutional investors or accounts (e.g., IRAs), restricting their demand and potentially limiting price appreciation.
- 1040 inconvenience: Investors may find that MLPs create tax disadvantages and inconvenience on their personal income tax returns.
- Political risk: The tax advantages of MLPs can be eliminated by changes to federal tax code or changes in state and federal laws that govern the oil and gas industry.
Final Thoughts
It’s essential that investors understand that MLPs must be evaluated with different financial metrics than common stocks. For example, an investor needs to consider an MLP’s distributable cash flow, distribution coverage ratio, access to cash and credit lines, and its debt-to-EBITDA ratio to understand what represents good investment value.
An experience financial advisor can help individuals answer some important questions when considering investments in MLPs, such as “How much of my portfolio should be in MLPs?”, “How do I build a diversified MLP exposure in my portfolio?” and “What MLPs represent the best balance of high income and personal risk tolerance?”
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.