An Introduction to MLPs

With interest rates still at historic lows, the current economic environment presents obstacles for investors seeking an attractive risk-adjusted yield.  As an alternative solution, investors should consider an allocation to master limited partnerships (MLPs).

In addition to offering attractive yield opportunities, MLPs have intriguing tax advantages, contain a degree of inflation protection, and can provide diversification benefits to a portfolio.

An MLP is an infrastructure company organized as a partnership (rather than a corporation) that trades on a public exchange or market. It combines the tax benefits of a partnership with the liquidity of publicly traded securities. Congress recognized MLPs in the 1980s to encourage investment in energy and natural resources companies. In order to qualify for MLP status, a partnership must generate at least 90% of its income from what IRS deems “qualifying” sources, which generally includes all manner of activities related to the production, processing, or transportation of oil, natural gas and coal. Due to these stringent provisions, energy related businesses compose 75% of the MLP universe, with financial, consumer discretionary, utility, materials, and industrial companies rounding out the balance. To provide an example of a MLP company, think of a business that transports natural gas through a pipeline network.

Contrary to corporate shareholders, investors in MLPs are known as unit holders, or limited partners (LPs) and the managers of MLPs are known as general partners (GPs). Shares are referred to as units and payouts are made as distributions as opposed to dividends. The GP has full management responsibility of the business and typically holds a minority stake. The LPs own the remaining interest in the partnership but play no role in daily operations and typically have no voting rights.

The yield opportunities of an MLP make it very attractive in a low interest rate environment. Partnership agreements typically require MLPs to pay out all of their available cash flow in the form of quarterly distributions, which provide a steady yield stream for the investor. Currently, the average MLP yields more than 6%, which is greater than high-yield corporate bonds. The yields are not only attractive today, but their growth prospects remain compelling. Demand for energy and MLP-related services is relatively stable, meaning future distributions should not be adversely affected by market conditions. Since the asset class is still relatively young (about 90 MLPs in total) and investments in energy should continue to keep pace with rising energy demand, MLP distributions may continue to increase for the foreseeable future.

In addition to the yield opportunities, MLP investments can offer significant tax advantages for taxable investors.[1] To illustrate, in the case of a corporation, income is first taxed at the entity level (i.e., the corporate rate), and then taxed again when distributed via a dividend to shareholders at the dividend rate. In the case of an MLP, because it is structured as a partnership, there is no entity level tax. This results in larger cash distributions to its owners, all else equal, because the entirety of the MLP’s income is available for distributions rather than just the remaining portion after the entity tax. Additionally, the majority of the distribution portions are tax-deferred. As MLPs tend to be capital intensive businesses, the LP unit holders can benefit from their proportionate share of depreciation and/or depletion deductions. Since these deductions reduce taxable income without impacting the cash available to the unit holders, distributions tend to be very tax-efficient, with a significant portion of each distribution treated as a tax-free return of capital. Commonly, only about 10% to 25% of the investor’s distributions are recognized as taxable income (typically at the investor’s ordinary income tax rate). Any tax on the balance of the distributions is deferred until the sale of the LP unit. The benefits of entity tax pass-through treatment and tax-deferral characteristics are some of the most attractive features of MLPs for investors, especially in the current environment where taxes on investments have increased for most wealthy investors. [2]

MLPs can also help mitigate concerns that certain S corporations may have regarding the generation of passive investment income. Generally, S corporations with accumulated earnings and profits earned before electing S corporation status are subject to an entity level tax on the net passive investment income (i.e., royalties, rent, dividends, interest, and annuities) generated in excess of 25% of the corporation’s total gross receipts. Further, the S corporation election will be automatically terminated if the corporation is subject to this tax for three consecutive years. Since the distributive share of gross receipts from a partnership, rather than its share of the venture’s net income or loss, is used in applying the passive investment income tests, MLP gross receipts passed through to an S corporation are not considered passive investment income. Accordingly, holding investments in MLPs should be beneficial since they will generate an additional source of gross receipts that are not included in passive investment income.

Many MLPs also have inflation protection built into their revenue flows. The Federal Energy Regulatory Commission allows certain tariff-based MLPs to increase their pipeline fees according to the Producer Price Index (PPI), and many storage contracts adjust to the Consumer Price Index (CPI), so any rise in inflation is at least partially offset by these pricing abilities.

Aside from the above advantages, MLPs are suitable in a portfolio context due to the diversification benefits. As can be seen in the table below, MLPs have historically demonstrated a low correlation to other asset classes. Therefore, including MLPs in a portfolio may decrease the portfolio’s overall risk.[3]

Asset Class Correlations

November 2003 to April 2012

Asset Class	U.S. Long Term Treasuries	U.S. TIPs	High Yield Bonds	S&P 500	Gold
Alerian MLP Index	-0.44	0.12	0.63	0.49	0.03

 

As with all types of investments, there are important risks to consider before investing in MLPs. Regulatory risk poses the most significant threat, as an elimination of the entity tax exemption or the pricing abilities stated above would have a tremendous impact on MLP valuations. Other considerable risks are interest rate risk and credit risk. MLPs rely on the capital markets to finance growth, so a decreased credit rating and/or rise in interest rates would increase their cost of capital.

In addition to the investment risks, there are several important tax reporting and compliance considerations specific to MLP investments. As MLPs generate taxable income, investors may be required to file tax returns in the numerous states in which an MLP operates. This can create a large burden, as in the case of the pipeline MLP example above, which typically runs through many states. Additionally, MLPs that generate losses can be even more onerous from a tax compliance standpoint due to the strict limitations on losses that flow through to investors. Consequently, the investment community has responded to the tax compliance concerns by creating ways to gain exposure to the asset class through vehicles such as mutual funds, ETFs, ETNs and total return swaps. These solutions, however, generally sacrifice a few of the potential tax benefits associated with direct ownership of MLP units in exchange for simpler tax compliance. Accordingly, it is very important to coordinate a decision to invest in MLPs with both sophisticated investment and tax advisors to determine if MLPs are an appropriate fit for your portfolio.

 

[1] Due to the partnership status, tax-exempt investors are subject to unrelated business income tax (UBIT), which might not be desirable.

[2] The depreciation and depletion deductions mentioned above can also mitigate the impact of the new Unearned Income Medicare Contributions Tax of 3.8% for investors subject to that tax.

[3] A low correlation between assets indicates that there is a weak relationship between their returns; as a result, risk is mitigated since there is less likelihood that both assets will decrease to the same extent.