TAX NEWS - JUNE 2010

Tax advantages of Master limited partnerships (MLP)

Master limited partnerships (MLP) have been around for almost three decades -- Apache Oil Company, the first such partnership, launched in 1981 -- but these forbearers differed greatly from the modern-day incarnation. Though intended to facilitate investment in the energy industry, early MLPs gravitated toward exploration and production but also engaged in a wide range of other businesses.

By the end of 1986, there were 34 MLPs that operated outside the oil and gas industry, including offerings involved in restaurants, nursing homes, cable television and mortgage banking.

But many investors learned the hard way that cyclical businesses didn't necessarily lend themselves to the MLP structure; the worst offerings failed to generate sufficient cash to support their high, tax-advantaged yields.

The modern Master limited partnership (MLP) traces its roots back to the Tax Reform Act of 1986 and the Revenue Act of 1987, which required master limited partnerships to generate at least 90 percent of their income from "qualified" sources--many of which were related to natural resources.

Over the past year energy-focused Master limited partnerships (MLPs) have become more popular for the very same reasons as in the mid-1980s: high yields and tax advantages.


A Compelling Case

Yield chasers have long flocked to MLPs. An article in the March 19, 1987, edition of the Wall Street Journal noted that "in order to be competitive" a Master limited partnership (MLP) needed to offer a 9 to 10 percent yield.

Today, MLPs are an attractive alternative to a frothy bond market, where spreads on high-yield issues appear insufficient to compensate for underlying risks. And whereas the average stock in the S&P 500 offered a dividend yield of just less than 2 percent at the end of the first quarter, the Alerian MLP Index yielded roughly 7 percent.  

MLPs also offer significant tax advantages. As pass-through entities, MLPs don't pay federal income taxes at the corporate level. They spread this responsibility among unitholders.

This tax relief is a huge advantage when these firms compete with traditional corporations for acquisitions -- one way in which MLPs grow their distributions. And investors avoid the double taxation to which corporate dividends are subject. (The government taxes corporation's earnings as well as the dividend payments received by individual investors).

Better yet, the Internal Revenue Service generally treats 80 to 90 percent of the distribution investors receive as a return of capital, limiting current tax liability. Rather, the amount paid is subtracted from the cost basis; taxes are due as a long-term capital gain when you sell your position.

In other words, 80 to 90 percent of the distribution you receive from an MLP is tax-deferred. The remaining piece of each distribution is taxed at normal income tax rates, not the special dividend tax rate. But the piece taxed at full income tax rates is only 10 to 20 percent of the total distribution--a substantial deferred-tax shield.

The group will become even more attractive in 2011, when the top rate on dividends will increase from 15 percent to 20 percent in the best case or nearly 40 percent in the worst case.


The Dangers of Nearsightedness

High yields and tax advantages are a compelling proposition at a time when many investors are seeking to recover losses suffered during the financial crisis and market implosion and cowering in fear before the prospect of higher taxes.

Speculation that the Obama administration would eliminate MLPs' tax advantages are farfetched but remain a major concern for some enervated investors.

Legislative efforts to crack down on tax loopholes enjoyed by investment firms organized as MLPs also have many investors worried that the tax advantages enjoyed by energy-focused partnerships could also be at risk.

Elliott H. Gue, editor of The Energy Strategist and co-editor of MLP Profits, addressed these concerns definitively in the Jan. 2, 2010, issue of Personal Finance Weekly, Don't Get Carried Away. But some investors began to fret once again after Senate Finance Committee Chairman Max Baucus and House Ways and Means Committee Chairman Sander Levin unveiled the legislative text of The American Jobs and Closing Tax Loopholes Act (HR 4213).

This revenue-raising proposal, which has the support of the Obama administration, applies only to the taxation of "carried interest" paid out to fund managers as compensation for their services. Depending on how the partnership earned this carried interest, it could be taxed as long-term capital gains rather than ordinary income; the bill would tax this compensation at the higher, ordinary income rate.

Rest assured: This is a non-issue for investors in energy MLPs -- the carried interest income they generate isn't capital gains and has always been taxed at ordinary income tax rates. Investors concerned that this marks lawmakers' first foray into eliminating the tax advantages associated with Master limited partnerships (MLP) should note that in 2008 Congress expanded the definition of qualified income sources to include biofuels. That the current proposal before Congress doesn't specifically address energy MLPs likewise suggests that lawmakers understand the key role these partnerships play in developing and maintaining the country's energy infrastructure.

And all too often investors focus on a partnership's yield, rather than its underlying business. This shortsightedness is hardly a new problem. Writing for the Wall Street Journal back in March 1987, Barbara Donnelly noted, "Investors are focusing too much on yield, ignoring whether the underlying business can really support such high payouts."