1 Great MLP and 1 Unique Alternative to Buy Right Now

Income investors love MLPs (master limited partnerships) for their high yields but often dislike the added tax complications that come with them. Sometimes the general partner (gp) of an MLP is also publicly traded. Investors can become confused as to the difference between these entities and which is better. The purpose of this article is to clear up this confusion. Also, I will point out a deeply undervalued general partner that is currently trading at a high yield and with excellent prospects for future growth. 

The difference between MLPs and general partners
MLPs are managed by general partners (gp) who hold incentive distribution rights (IDRs) and typically also own a large portion of the MLP's units. For tax purposes, MLPs don't have shareholders, but rather unit holders, who are paid distributions rather than dividends. The key difference between distributions and dividends is that a large portion of a distribution is treated by the IRS as "return of capital" (ROC). How much is ROC versus regular income versus capital gains is stated in the annual K-1 form, which is sent out by the MLP each year (as opposed to a 1099 form).

The ROC component of the distribution is subtracted from the cost basis until the basis hits $0. At that point, all further ROC portions of distributions are treated as long-term capital gains. This tax deferral is one of the primary benefits to owning MLPs (other than high yield). If an investor holds an MLP forever than the deferred taxes will never be paid to the IRS. In addition, long-term capital gains are taxed at a max of 20% (most tax brackets 15%). This makes MLPs a tax-advantaged income source.

One additional important tax consideration to understand with MLPs is unrelated taxable income (UBTI), which is the portion of the distribution that is paid from taxable earnings. Why UBTI is important is because even if MLPs are held in a tax deferred account (such as an IRA), UBTI is still owed to the IRS. This is why it's not advisable to own MLPs in tax-deferred accounts. This is where general partners come in. 

General partners are traditional corporations with shareholders who are paid dividends. Their shares typically have a smaller yield than their MLP counterparts but faster dividend growth rates. This is because the gp receives distributions from the units of its MLPs as well as the IDR fees. These fees are designed to send a greater and greater portion of marginal distributable cash flow (DCF) to the general partner when certain distribution milestones are reached -- up to a fixed maximum (typically 50%). 

The way most general partners operate is to purchase assets that are then "dropped down" to their MLPs. This means sold in exchange for cash, debt assumption, and additional units. In essence, general partners become the financiers of their MLPs and generate nearly all their income from distributions and IDR fees.

Which brings me to one of my favorite companies, one that offers an excellent investing opportunity right now. 

Linn Co LLC  (NASDAQ: LNCO  ) is not a traditional general partner to its MLP Linn Energy (NASDAQ: LINE  ) . Rather, it is a holding company whose sole purpose is to hold units of Linn Energy and pay out dividends (rather than distributions) to get around the tax issues mentioned previously. The yield (10.6%) is actually higher than its MLP (10.1%), but the investment thesis for both is the same.

Linn Energy's recent purchase of Berry Petroleum is partially the cause of its recent price weakness. The acquisition became non-accretive (too expensive) because Linn Energy paid in Linn Co shares, which fell due to accounting concerns now resolved. Thus, the amount of shares paid had to be increased (raising with the final cost). This is partially why management guided down the 2014 dividend coverage ratio to 1, creating concerns about dividend security. This concern is misguided due to three reasons.

First, 2014 production is expected to increase 3%-4% despite a 11% decrease in capital expenditure, or capex. This means improved profitability that will ensure the safety of the dividend.

Second, management is looking into options to trade or sell certain midland basin assets that require expensive drilling to bring online in exchange for (or to buy) assets with producing wells already active. Management believes this would increase DCF while lowering capex even further. However, even if management can't execute on this option the dividend is still safe.

Finally, management is actively searching for accretive acquisition targets (48 so far this year). They have bid on six (worth $5.5 billion). This is important for two reasons. By definition, accretive acquisitions instantly increase DCF/share, which helps to secure the dividend. Second, despite the Berry Petroleum acquisition, the company has an excellent history of accretive acquisitions (60 acquisitions worth $15 billion since the IPO in 2006).

Foolish takeway
MLP general partners can be a great way for investors to participate in America's energy bonanza without the tax complexity that MLPs bring. Linn is a special general partner that makes for an excellent investment right now. Its 10.6% yield is safe and with a likely 2%-3% dividend growth rate (five year average distribution growth 2.8%), it should return market-trouncing long-term total returns while creating high, dependable income. 

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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 April 25, 2014, at 2:23 PM, zorro6204 wrote:

    "The key difference between distributions and dividends is that a large portion of a distribution is treated by the IRS as "return of capital" (ROC)."

    Before you write an article that includes information about taxes, you might spend five minutes on Google doing a little research. "Treated by the IRS." The IRS doesn't "treat" anything, they're an administrative agency, Congressional law provides how publicly traded partnerships work. And the distributions are not a "return of capital" in the sense you mean. It's just that LINE, and other typical upstreams, have a lot of preference tax deductions in the form of intangible drilling costs and percentage depletion that offset the income from operations, which often results in negative taxable income. That negative income isn't immediately deductible due to the passive loss rules applied to publicly traded partnerships, but it means that the cash flow you receive is tax-free, in the sense that no accompanying taxable income exists to cause a tax liability.

    All of this and a lot more is easily found simply by Googling "MLP taxation".

    There's a ton more nonsense in the article, like "The way most general partners operate is to purchase assets that are then "dropped down" to their MLPs." No, that is not typical, it happens only in those cases where a private sponsor like Natural Gas Partners or QR Energy syndicates a partnership and moves mature properties into it in order to recover capital for other purposes. LINE has no sponsor, and it represents half the upstream space all by itself. Nether does BBEP or VNR, two of the larger upstreams in the other half of the space.

  • Report this Comment On April 25, 2014, at 4:09 PM, AdamGalas wrote:

    My apology for the confusion.

    I wrote this article as a broad primer on MLPs and my reference to general partners dropping down assets to its MLPs was specifically in reference to the midstream space.

    Kinder Morgan, Spectra Energy, Phillips 66, and many others, all perform this action repeatedly.

    I didn't mean to create confusion and was simply attempting to provide a general idea of how MLPs work, the tax headaches and benefits and why investors might want to consider owning a general partner in addition to (or instead of) the MLP.

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