Are Master Limited Partnerships Worth the Trouble?

Income-hungry investors have turned to a number of previously unknown investments in the search for bigger payouts. In many cases, they've been successful in finding some lucrative opportunities. In the process, though, they've also unearthed some complicated issues to resolve, especially on the tax front.

One of the best examples of this phenomenon is the master limited partnership. MLPs have some very attractive attributes, most notably the huge distribution yields that many of them offer. But those distributions come at a price, and if you don't want to deal with the complications, it'll cost you.

The best of MLPs
It's no secret why MLPs have attracted so much attention. On one hand, the huge amount of energy-related activity in the U.S. has led to a big expansion in the need for the sort of commercial projects that MLPs often take on. For instance, major MLPs Kinder Morgan Energy Partners (NYSE: KMP  ) and Energy Transfer Partners (NYSE: ETP  ) both specialize in midstream energy operations, including pipeline transmission and storage facilities, which have become increasingly important as oil and gas production levels throughout the country have risen.

More importantly from an investor's perspective, these activities produce substantial profit and cash flow, and thanks to special treatment from the IRS, MLPs are able to distribute the lion's share of their income out to investors. That's why Kinder Morgan yields about 6%, while Energy Transfer and Enbridge Energy Partners (NYSE: EEP  ) weigh in at around 7.5% to 8%.

The yields that MLPs pay compare very favorably with those of traditional energy companies. Most of the major integrated oil and gas companies have dividends in the 3% to 5% range. Downstream refining companies often have even lower yields, with HollyFrontier (NYSE: HFC  ) paying just 1.5%, while Valero (NYSE: VLO  ) yields 2.4%. Because those corporations have to pay taxes at the corporate level, they can't afford to distribute as much money to their shareholders as MLPs do.

The tax twist
In fact, in some cases, MLPs give their investors an added bonus. Even though MLPs make large distributions, not all of what investors receive from their MLPs' units is subject to current tax. Typically, MLPs have cash flow that exceeds their taxable net income, because MLPs enjoy deductions for depreciation for equipment and depletion allowances. Those deductions reduce taxable income, saving you money when you file your taxes.

But if you think that money is tax-free forever, think again. The IRS treats the amount of money that you receive from an MLP that isn't taxed as a return of your capital. In most cases, you won't have an immediate tax problem, but down the road, those distributions can catch up with you.

What return-of-capital distributions do is reduce your tax basis in your MLP units. As your basis drops, the amount of potential taxable gain when you sell your units goes up, as the IRS will effectively recapture that lost tax liability when you decide to get out of your investment. Even worse, if you use up all of your tax basis before you sell, then any excess money you get from the MLP is treated as ordinary income to you.

As if that weren't bad enough, it can be difficult to figure out what type of gain you have when you sell. Typically, if you have a gain on a regular stock, you'll pay favorable capital-gain tax rates when you sell. But with MLPs, a portion of your overall gain that results from the reductions in your tax basis may be subject to ordinary income tax rates for things like depreciation recapture.

Simplicity at a price
What all those complex provisions boil down to is that MLPs can be a pain at tax time. Yet while you can avoid those hassles by using other investment vehicles like exchange-traded products, some of them cause you to lose many of the tax benefits that MLPs offer. Whether that turns out to cost less than what your accountant charges is an important question to ask.

MLPs can be useful for income investors, but they're far from simple. Whether they're worth the extra hassle depends on your level of tax expertise and how willing you are to deal with special rules to reap lucrative benefits.

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Fool contributor Dan Caplinger thinks saving on taxes is always worth the hassle. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't cost you a dime.


Read/Post Comments (13) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 21, 2012, at 9:46 AM, bpkarns wrote:

    Would these be great additions to a Roth IRA since the tax issues would be a mute point?

  • Report this Comment On August 21, 2012, at 9:50 AM, Retiree2035 wrote:

    What are the tax implications if I buy an MLP in an IRA Roth?

  • Report this Comment On August 21, 2012, at 9:51 AM, Retiree2035 wrote:

    bpkarns:

    I believe there are still tax implications in an IRA Roth. I just asked a similar question. I believe the UBTI tax rule applies to dividends over $1,000 per year, however, I am not sure.

  • Report this Comment On August 21, 2012, at 9:58 AM, mr091468 wrote:

    To circumvent the tax problems we have KMR in our taxable accounts and TYG and TPZ in our tax deferred accounts. All have respectable dividend percentages. KMR and TYG pay quarterly and TPZ pays monthly. GLTA.

  • Report this Comment On August 21, 2012, at 11:06 AM, mdk0611 wrote:

    Agree with retiree. You may have to deal with the UBTI rules if you hold in a Roth or tradtitional IRA.

    With respect to taxes, in addition to the federal issues MLP's can also complicate your state tax picture, with potential filing requirements in a number of states.

  • Report this Comment On August 21, 2012, at 11:48 AM, stevhoff wrote:

    Actually HFC's past 1 year yield is much higher as they have been paying special quarterly dividends of $.50/share in addition to the regular quarterly of $.15.

  • Report this Comment On August 21, 2012, at 5:50 PM, wolfhounds wrote:

    The tax issues are exactly why have held, what is now $300,000 with reinvestments, KMP &ETP for many years. The deferred losses and Sec (59)(e) amortization expenses can be used to offset high income years by selling the units then buying them back after 30 days. See your accountants for advice.

  • Report this Comment On August 24, 2012, at 1:23 PM, 3crowns21 wrote:

    My tax-accountant said that MLP Penn Virginia Resources, sporting 8-9% dividend, would cost me an extra $150 per year in tax-preparation because the MLP forms are so complex. He also said that many MLPs are late sending out the K-1 tax forms.

  • Report this Comment On August 24, 2012, at 2:10 PM, bmowers wrote:

    You have to enter the K1 partnership into your return. I use turbo tax for my tax prep and this takes 5 minutes and the program keeps track of all needed information. Most tax accountants use similar software. Your getting ripped off by your accountant who now has an excuse to charge you more. Yes the seem to be slow with the k-1's but this last year they all met the deadline and most are available on line ahead of time.

  • Report this Comment On August 24, 2012, at 2:17 PM, bmowers wrote:

    bpkarns: is right about the UBIT issue of holding MLP's in a retirement account. Don't make that mistake like I did. I hand to do a lot of portfolio juggling to correct the situation. Wish the media stressed this more often. Besides holding MLP's in retirement accounts does not take advantage to some of the tremendous tax advantages of MLP's.

  • Report this Comment On August 25, 2012, at 8:11 AM, BellbrookCPA wrote:

    3crowns21: Your tax-accountant is indeed ripping you off by stating that it will cost an additional $ 150 to do a K-1. K-1's typically have about 5 lines at the most of inputted information. MLP's are not that complex in my opinion, however I have only been doing taxes for 35 years. Turbotax is pretty good with K-1's.

  • Report this Comment On December 20, 2012, at 10:04 AM, DickFL wrote:

    I am a tax preparer who works for H&R Block. In most cases there is no additional charge for entering data related to MLPs unless additional state returns are necessary. If MLPs are in an IRA, there is no tax

    impact until the proceeds are taken out of the IRA.

    Then the distribution is treated the same way any other distribution i treated.

  • Report this Comment On January 03, 2013, at 3:13 PM, njshore111 wrote:

    I bouth 2 MLPs in 2012 and did not sell them. Are the distributions/dividens I recieved in 2012 taxable even though I have not sold my MLP stocks?

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