Everything You Need to Know Before Investing in MLP Funds
May 5, 2017
Master Limited Partnerships (MLPs)
Have you ever looked for a dividend stock that provides deferrable taxes? And wanted a dividend-paying stock that has steady and predictable earnings at the same time.
Well, there’s one way to obtain both: a master limited partnership (MLP). These companies have preferred tax treatment at the corporate level, making them more than worth consideration.
Now, you may want to know a more in-depth MLP definition, how to invest in MLPs, and/or the MLP investments’ tax implications. All of this and more will be explained below.
What is An MLP Fund?
Companies that would be classified as master limited partnerships are all based in the U.S., and both private and public companies are eligible. An MLP is required to pay out at least 90% of its income in dividends, which works out well since MLPs tend to have a predictable income stream. MLPs do not pay tax at the corporate level.
Every MLP is categorized as either a limited partnership or a general partnership. Limited partnerships are those in which investors purchase shares in the company and receive income. The money used to buy the shares is put towards the company’s operating costs. Most limited partnerships are publicly traded companies.
With general partnerships, management—who are responsible for the company’s daily operations—would also be considered part owners. Rather than receiving a steady salary, a compensation payment is made through the MLP and is based on its performance. General partnerships are usually private companies.
What Are MLP Investments?
Generally speaking, MLPs are only certain types of companies: energy MLPs, financial MLPs, and real estate MLPs.
The most common MLPs are energy companies that operate pipelines, rail terminals, processing and storage plants, and the transportation of oil and natural gas. Most companies that fit this profile would be publicly traded limited partnerships.
Financial MLPs tend to more often be private general partnerships. This is because the capital of these firms is generally invested in structured products such as mutual funds and hedge funds.
Lastly, there are real estate MLPs, which are not commonly found. These are companies that generate earnings through rental income. The reason these are very difficult to find is that real estate companies have been structured as real estate investment trusts (REITs). REITs have their own tax advantages and rules and, in turn, their own benefits.
How Are MLPs Taxed?
MLPs do not pay tax on corporate earnings as long as that specific MLP’s rules are followed. With no taxes due at the corporate level, at least 90% of the MLP’s profit must be paid to investors. This would result in taxes being paid by the investor. Further below are more details on how investors must account for taxes.
How Are MLPs in the Hands of Shareholders Taxed?
The biggest advantage of a receiving a dividend from a MLP is the tax deferrence benefit. The benefit is based on how the dividend is paid. The dividend is given to shareholders in the form of a return on capital, and taxes are due when the shares are sold.
Here’s an example. Lets say you purchase 100 shares of an MLP at $15.00; this would amount to a total of $1,500. The annual dividend is $185.00, and the return on capital is going to affect the average purchase price. So, after one year, the average purchase price is going to decrease to $13.15. The average price is calculated as followed:
Total amount initially invested: $1,500
Dividend received: $185.00
New total average cost = $1,315 ($1,500 – $185.00)
Average per share = $13.15 ($1,315 ÷ 100 shares)
The average share price would continue to decrease as each dividend is paid. This calculation is normally done by the broker.
So, in the above situation, there would be no taxes to be paid on the $185.00 dividend. Instead, taxes would have to be paid when the shares are sold, and there would be either a capital gain or loss based on the selling price minus the new average price per share.
If the shares were held for a long time and the cost basis happens to go to zero, the dividend income would be taxed as ordinary income.
The reason that a MLP is set up like this is that, when an investment in made into a company, the capital is used for operating the business. As a result, the dividend is paid out using the capital that the investment was made with. This is also why it is called a return on capital, since investors are getting their money returned.
What Are the Best Ways to Invest in MLPs?
There are many different ways to get exposure to the different forms of MLPs. In the case of a general partnership, a business’s startup may require a capital investment from a few other individuals. This would require an active role in the general partnership to ensure profit. This is important because compensation would only be received if the business is generating positive cash flow.
A general partnership may require a large amount capital so, for those who do not have large sums of money, a limited partnership would be best. When it comes to investments within a limited partnership, there are many different ways to get exposure. Here are just some of them.
1. Brokers
A broker provides two options to investors. The first is that those who are managing their own investment portfolios can simply purchase the shares electronically through the brokerage.
If you have an advisor managing your portfolio, then simply communicate to your broker and they would execute the trade on your behalf.
The income that is paid out will be added to either the cash portion of the brokerage account or your personal bank account.
2. Exchange-Traded Funds
If you don’t want exposure to only one MLP, then consider an exchange-traded fund (ETF). This is because the ETF will hold many companies within its portfolio. In fact, just one ETF will provide diversification within a market segment. ETFs trade on the major exchanges, just as stocks do.
Some ETFs will continue to follow the model of a MLP, with a dividend being paid on a monthly or quarterly basis.
Professional portfolio managers make the decisions regarding allocation of the capital within the ETF. They are also the ones who make any changes, such as decreasing or increasing a position, as well as determining the payout’s frequency, amount, and any possible increases.
3. Mutual Funds
Mutual funds are similar to an ETF, in that they hold many positions; they’re essentially an older version of an ETF. A mutual fund is normally priced at the end of the day and calculated once the market is closed. The value is known as the net present value of the fund.
With this investment vehicle, there are times when there is a minimum for both the holding period and amount invested. The advantage this has over an ETF is that the market cannot control the price of the fund and, therefore, swing in an unfavorable direction. This is because the price of the fund is based on the true value.
4. Deal with the Company
If you want exposure to only one company and to hold the shares in paper form, this can be done through the company directly. The income would be received as a check in the mail, though the option to hold the shares electronically would remain.
With this method, the company decides if it wants to deal with shareholders on an individual basis. For companies that do not provide this method, it just means that the shares must be purchased on the trading exchanges with a broker.
Should I Invest in An MLP?
Income investors should not ignore MLPs, because of their safe income stream. Keep in mind that many MLPs offer a dividend yield and normally pay a quarterly dividend.
Many MLPs are also protected from inflation. For instance, when inflation is affecting operating costs, it gets passed along to the end user of the services. This keeps the business’s margins steady, which means that there is a possibility for the dividend to increase.
With strong margins, they should see a gradual increase, leading to a positive return when the income and capital gain are calculated.
Who Cannot Invest in MLPs?
Your broker may have their own set of rules that state that MLPs cannot be purchased within an investment retirement account (IRA). If so, it’s likely because of instances when taxes have to be paid on the income that is earned from the MLP. This will depend on the business operations of the MLP itself. In most cases, if more than $1,000—known as unrelated business taxable income (UBTI)—is earned within an IRA by an MLP, then taxes would have to be paid, with the amount based on the income level.
The best thing to do is check with a broker to ensure that the MLP can be held. The broker can also help you understand the tax situation so there are no surprises.
How Do I Invest in an MLP for Retirement?
The above information is proof that the government discourages investors from holding an MLP within an IRA. However, there is a tax strategy that benefits investors when they own an MLP in a taxable account, called an investment account (IA).
Let’s say you have an IA and and IRA account and you want to own MLPs. With a well-diversified portfolio containing various asset classes, an MLP would prove to be more beneficial in an investment account (taxable account).
In this example, let’s a compare an MLP and a normal dividend-paying stock. Now, normally, when a stock is held in an IA, taxes would be due on the capital gain/loss when the position is sold, as well as on generated income.
When an MLP is held in an IA, no tax has to be paid on income, since taxes are deferred until the shares are sold. At this point, a capital gain/loss would then need to be calculated. When taxes have to be paid on a capital gain, it is at a lower preferred tax rate, provided it meets the criteria.
IRAs are accounts are meant for retirement, and there are tax benefits that come with them. Taxes do not have to be paid on capital gains and income until money is taken out of the account, which has nothing to do with investing.
As mentioned earlier, MLP benefits investors more in an IA. That’s because there is no tax paid on the income, compared to a traditional dividend-paying stock in a taxable account. The capital gains will be the same no matter if it’s an MLP or a traditional stock, so they offset each other.
So, the best way to invest in an MLP is by holding it within an investment account, while a dividend stock should be held within an IRA. This way, there is no tax being paid on both income sources.
Final Thoughts About MLPs
A master limited partnership is a great way to invest and generate a steady income. Just like you have your own investment goals to earn income, companies are focused on the same thing. And don’t forget all the tax benefits, since they are so often deferred.
