How MLPs Work: A Beginning Guide for Dividend Investors

There's a lot of buzz around MLPs these days, but what's all the fuss about?

The Alerian MLP Total Return Index -- considered the leading gauge of energy MLPs -- is comprised of 50 energy MLPs, and has managed to edge out the S&P 500 index on a total return basis by 51% over the last five years.

Source: S&P Capital IQ.

Dividend investors have been gravitating toward these investments seeking to profit from the high yields that have made MLPs so popular. Before joining the herd, though, you need to know how MLPs work.

What's different about MLPs?

A master limited partnership -- affectionately known as an MLP -- is a publicly traded partnership, most of which are comprised of a general partner who manages day-to-day operations, and you, the investor, who acts as the limited partner. Unlike owning shares in a company and receiving dividends, MLP investors own units and receive cash distributions in reward for supplying capital to the venture. By the nature of its legal classification, an MLP must derive at least 90% of its cash flows from natural resources, commodities, or real estate. As with any investment, it's vital to understand how these cash flows are generated.

Turn up the volume

One of the most common segments in which energy MLPs conduct business in the U.S. is in natural gas midstream operations. Take Energy Transfer Partners (NYSE: ETP), for example. This MLP generates revenue from intrastate natural gas transportation and storage. Fees are charged based on the volume of natural gas that flows through the partnership's transportation pipelines and on the amount of stored fuel customers choose to reserve. In this case, the MLP doesn't own the commodity, which means less exposure to price fluctuations. Increased volume and increased storage represent two key revenue drivers that could translate into larger cash distributions for unitholders.

There are certainly other ways in which MLPs generate revenue. An upstream MLP, operating in the exploration and production of oil, has different strategic objectives and is influenced more by the rise and fall of oil prices. What's important is that you understand what those revenue streams look like, the risks involved, and how you benefit as a unitholder.

Sounds simple, right? Great. Let's talk taxes...

Taxes take a backseat... sort of

One of the most touted advantages of owning MLPs is that taxes on distributions are deferred, whereas corporate dividends can present you with taxable investment income in the year received. In most cases, this is true.

Thanks to their structure, MLPs not only pass on the majority of their earnings to unitholders, but also transfer deductions like depreciation and depletion. These deductions reduce your cost basis and lower your taxable income.

Distributions that exceed your share of the MLP's net income are considered a return of capital, which means taxes are deferred until you decide to sell your units. And when that time comes, you pay the lower capital gains tax on that return of capital as opposed to ordinary income tax. So far, so good.

Once your cost basis reaches zero, however, distributions are taxed as capital gains in the year received. While rare, any additional non-qualified income generated by the MLP is taxed at ordinary income rates. This is why it's important to keep track of your cost basis when owning MLP units to avoid paying additional taxes.

When units are sold, your gain is taxed in two ways. The first portion of your gain -- the difference between the selling price and your adjusted cost basis -- is taxed at capital gains rates. And although depreciation deductions allowed you to lower your cost basis while holding those units, this second portion of your gain -- resulting from basis reductions due to depreciation -- is going to be taxed as ordinary income. Uncle Sam calls this depreciation recapture.

As you can imagine, tax reporting is often complex when you're investing in MLPs. In addition to determining which tax to pay on what type of gain, you need to be aware that MLPs can operate and hold income-generating properties across multiple states. If you're a large unitholder and meet state-specific income thresholds, this could mean needing to file taxes for several different states. This cumbersome tax information is disseminated annually by the MLP through what is known as a K-1 form. The K-1 will detail your share of the MLP's net income, deductions, and distribution information, which can be overwhelming, to say the least. If you're not the type of investor that enjoys poring over complicated tax documents, there are alternatives.

Ways to invest in MLPs

There are a number of mutual funds and exchange-traded funds that offer exposure to MLPs while simplifying tax filing. The funds will handle the unwieldy K-1 and send you a more familiar 1099 form. But that's about the extent of the good news.

The bad news is that most open-end MLP funds have more than 25% of their assets in MLPs, which means the fund loses its regulated investment company status and becomes taxed as a corporation at a higher rate. This will effectively eat into your gains.

Even worse, owning an MLP directly in a retirement account such as a 401(k) or IRA could subject you to something called unrelated business taxable income, or UBTI. The income generated by MLPs is generally unrelated to the retirement account's tax-exempt status. Your combined share of net income and distributions from the MLP that exceed $1,000 get hit with unrelated business income tax, which is paid out of the account's funds. Call me old-fashioned, but I'd rather not forfeit my gains to cover additional taxes and fees.

Another option is to purchase shares of the MLP's general partner instead of limited partner units. If organized as a corporation, investment in the general partner would eliminate the hassle of dealing with the K-1 form, but you miss out on the aforementioned tax advantages. Some investors prefer this type of stake because of the incentives the general partner has to increase the MLP's distribution. This can translate to disproportionately higher distribution growth rates for the general partner, but often at lower yields.

Choose wisely

Owning an MLP through a regular brokerage account will allow you to take full advantage of its tax benefits as long as you're willing to stomach the tax complexity. For those who still want exposure to MLPs and prefer the simplicity of a 1099 form, there are several closed-end mutual funds with MLP assets under the 25% threshold worth examining. Whichever route you decide to go, understand that MLP distributions are treated differently than company dividends, can carry hefty tax complications, and are based on a stream of distributable cash flows unique to the segment in which the MLP operates. As an investor new to MLPs, make sure you consult with a tax professional before taking a position. You'll be happy you did.