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).
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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Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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 Motley Fool has a disclosure policy.