This is part II of the series, Unconventional Income From Uncommon Stocks. The series is meant to be an absolute beginner’s introduction to uncommon stocks. The focus of this post is on MLPs.
Before I answer this question, here’s one for you! What’s strikes you as most unusual from this list of MLPs?
|Master Limited Partnerships||Market Cap|
To be impartial, I picked every 5th stock from Morningstar’s data for industry peers for one of the largest MLPs, Kinder Morgan Partners
If you felt the dividend yields were quite attractive, congratulations! You have your eye on the money! One of the characteristics of MLPs is that they pay generous dividends and most have attractive yields. In fact, MLPs are required to pay out at least 90% of their income as distributions to it’s investors.
How Do MLPs Manage To Pay Out Fat ‘Dividends’?
If MLPs are required to pay out 90% of their income, how do they stay in business? Not paying corporate taxes is a good start! That’s right, MLPs don’t pay any taxes either at the Federal or the State level. Instead, that burden is passed on to you, the investor!
Which is not necessarily a bad thing. This avoids double taxation other regular corporations are subjected to. Taxed once at the corporate level and again at the individual investor’s level on dividends.
No Corporate Tax? Why Aren’t More Companies Joining The Party?!
Now not having to pay corporate taxes is very attractive for any business. Some go to great lengths to avoid paying taxes! What’s stopping a regular corporation from becoming an MLP?
Not all companies can become an MLP. A business needs to meet certain criteria in order to qualify for MLP status.
- The business must generate at least 90% of its income from ‘qualifying sources’ as defined by the IRS
- These include activities related to real estate, commodities or natural resources
- An MLP must pay quarterly required distribution as outlined in the partnership agreement
In order to satisfy the last point, an entity must have a source of income that is very stable and recurring in nature. No wonder most MLPs are in the energy transportation (pipeline) business!
What Is An MLP?
MLP stands for Master Limited Partnership. MLPs are publicly traded partnerships. By buying MLP shares (called units) you become a partner (unitholder) and you pay your share of the partnership’s taxes.
Why Should You As An Investor, Care About MLPs?
MLPs are a sweet deal for businesses. What about the investor? Other than fat dividends (not a guarantee, mind you), why should an investor look at MLPs?
In order to understand the benefits of investing in MLPs, let’s compare investing equal amounts of money in two hypothetical companies – one is a regular corporation and the other example is an MLP.
- Capital Gains Tax assumed at 15%
- Income Tax Rate assumed at 30%
- In reality, these two rates vary depending upon your income limits
- Amounts in red indicate cash going out of your pocket, amounts in black indicate cash coming in
Example: Regular Dividend Paying Corporation
|YEAR I||YEAR II||YEAR III||NET|
|A||You buy 1000 shares at $10 a share||-$10,000|
|B||Annual Dividends at $1 per share||$1,000||$1,000||$1,000|
|C||Dividends taxed at 30%||-$300||-$300||-$300|
|D||You sell 1000 shares at $12 a share||$12,000|
|E||Capital Gains Tax at 15%||-$300|
The tax impact of buying shares in a regular dividend paying corporation is fairly straightforward.
- (A)You purchase shares
- (B)You may receive payments from the company called dividends
- (C)You pay taxes on the dividends received at your regular income rate
- (D)When you sell the shares, you pay taxes on any profit made at your capital gains rate (E)
Example: Master Limited Partnership
|YEAR I||YEAR II||YEAR III||NET|
|A||You buy 1000 units at $10 a unit||-$10,000|
|B||Cash Distribution of $1.50 per unit||$1,500||$1,500||$1,500|
|C||Your portion of MLP's taxable income at $0.50 a unit,|
taxed at 30% rate (1000*0.50*30%)
|D||You sell 1000 units at $12 a unit||$12,000|
|E||Capital Gains Tax on difference|
between sale price and purchase price ($12,000-$10,000)*15%
|F||Income Tax on difference between |
original purchase price and adjusted price ($10,000-$7,000)*30%
The tax impact of investing in an MLP is a little more involved.
- (A)You purchase units as you purchase shares in any other regular corporation
- (B)You receive quarterly payments from the MLP called distributions instead of dividends
- (C)The MLP will notify you of your share of the Partnership’s income
- (C)Unlike dividends, you don’t pay taxes on the entire amount of the distribution. You only pay income tax on your share of the income which is usually 10% to 20% of that year’s distribution, essentially differing taxes on the rest of the distribution till you sell your units! Tax deferral is one of the key advantages of an MLP
- (D)You sell units like you sell shares of a regular corporation essentially terminating your partnership in the MLP when you liquidate all your holdings in the MLP
- (E)Just like a regular stock sale, you pay Capital gains tax on any profit you made (difference between original purchase price and final sell price)
- (F)Here’s the part that confuses most! When you purchase a share of a regular corporation, the cost remains the same till you sell it (known as cost basis). In an MLP, your cost basis can actually go down every year you have a distribution (less taxes)! How? Because the distribution after taxes is treated as return of capital by IRS!
- To elaborate on the above point, the purchase price at the beginning is $10000, but in Year II, the cost basis is set at $9000 and $8000 in Year III! In fact this can go on till your recover all of your capital and the cost basis can go to 0 if you hold the MLP long enough!
- (F) To understand how the $7000 adjusted cost basis was arrived at, study the table below
|YEAR I||YEAR II||YEAR III|
|LESS CASH DISTRIBUTIONS||-$1,500||-$1,500||-$1,500|
|PLUS TAXABLE INCOME||$500||$500||$500|
If the investor continues to hold this MLP, assuming the distributions and income share remain constant (in reality, both varies, but to simplify this example, we’ll keep these constant), in year 10, the adjusted cost basis goes to zero!
Frequently Asked Questions (FAQ)
1. How do I know what my portion of an MLP’s taxable income is?
Just before tax time, MLPs send out a form called Schedule K1 to all its unitholders. This details the amount you owe among other details like deductions caused by depreciations.
2. Can I hold MLPs in a tax deferred account like an IRA?
Yes (some brokers may not allow this). Considering the additional paperwork involved with MLPs some hold them in IRAs. But this is not the most efficient use of an IRA. Most of an MLPs distribution is tax-deferred, hence keeping it in an already tax-deferred account isn’t very prudent.
Some MLPs provide I-Shares (Institutional shares) that mimic the corresponding MLP and safe to hold in retirement accounts.
3. Why doesn’t my broker allow holding an MLP in my IRA? Why does the broker care?
Some brokers simply don’t allow holding MLPs in a retirement account and they have a very good reason for doing so. This is due to a tax concept called Unrelated Business Taxable Income (UBTI).
In order to understand UBTI, consider a tax-exempt entity like a hospital or a university that earns profits from their food services or parking departments. These are essential services, but have nothing to do with the purpose for which these entities have been provided tax-exempt statuses! These will be treated as UBTI.
In a similar fashion, income generated by an MLP in a retirement account may be treated as UBTI. As long as UBTI generated by all such entities is less than $1000 per year, the account will not be subject to taxes. Anything beyond and the entity is subject to UBTI taxes.
Yes, one of the rare instances where holdings in a retirement account is subject to taxes.
Why should your broker care? Because, it is not you who’ll file this (form 990-T) but your custodian! And in order to avoid this, some brokers won’t permit MLPs in an IRA and other brokers charge a hefty fee if UBTI is triggered. Please check with your broker before adding MLPs to your retirement account AND you expect to cross the $1000 threshold.
4. How do I know my MLP’s UBTI?
Check Box 20, Code V in your MLPs Schedule K-1. If the sum total in box 20-V of all the MLPs held in your retirement account is greater than $1000, your custodian, not you, will have to file 990T and pay taxes.
5. “I like the benefits MLPs provide, but don’t want to deal with the additional paperwork come tax time”
If, after reading this post, you still aren’t convinced MLPs are worth the additional paperwork, then these are some alternatives you could consider!
1. MLP ETFs. You could invest in MLP ETFs that’ll send you a 1099 instead of Schedule K-1s. AMLP, Alerian MLP ETF tracks 25 MLPs from the Energy sector tracking Alerian MLP Infrastructure Index. This is also the first MLP ETF launched in 2010.
4. I-Shares. If you’d like to hold MLPs in a retirement account without having to worry about UBTI, invest in an I-Share (Institutional Shares). They pay distributions as shares and meant for holding in tax deferred accounts. EEQ and KMR both track their respective MLPs, EEP and KMP respectively.
5. Import Schedule K-1′s. If you don’t mind Schedule K-1′s but hate entering all that data manually come tax time, then I have the perfect solution for you! You can automate entering Schedule K-1s if you have Turbo Tax!
For a little bit of paperwork during tax time, MLPs provide relatively stable, tax-deferred income most suitable for taxable accounts. You not only get to enjoy regular payments, but get to bring down your cost basis with each distribution. And since the General Partner’s compensation is tied to the Limited Partner’s distributions, this serves as an incentive to maximize and grow distributions.
Disclosure/Disclaimer: Long on KMP. Meant for informational purposes only and should not be construed as investment advice. Not responsible for errors and omissions. Please consult your tax advisor.
If you liked this post, don’t miss Part I of this series, Unconventional Income From Uncommon Stocks – Royalty Trusts. Sign up to receive FREE future updates on this series.