In an investment landscapes characterized by low interest rates, potential for tax changes, and a U.S. energy renaissance, master limited partnerships (MLPs)—which invest largely in oil and gas assets—are experiencing a revival. MLPs were in vogue in the 1970s when taxes, interest rates, and energy prices were higher. Now, these investment vehicles are attracting investors once again.
But do MLPs fit into your investment plan? You need to weigh the potential advantages, including their high yield and tax advantaged status, as well as the drawbacks, such as tax reporting complexity, illiquidity, and other risks.
MLP basics, primary drivers
Master limited partnerships are publicly listed securities that trade much like a stock, but they are taxed as partnerships, not as corporations. The two main catalysts behind the increasing demand for MLPs have been the comparatively high yield that many offer and the potential tax advantages.
+ High yield
“MLPs have garnered a lot of attention (and assets) due to their high yields,” says Joanna Bewick, portfolio manager of the Fidelity Strategic Dividend & Income Fund (FSDIX) and Fidelity Strategic Real Return Fund (FSRRX). “Currently, the average MLP pays out an annual yield of 6.5% on the initial investment,” adds Dan Dittler, a research analyst with Fidelity who specializes in MLPs. Note that this return includes a return of capital. Most MLPs, if not all, are structured to return a high percentage of their earnings to the partners. Investors should use caution when investing in high-yield investments that they are not familiar with or do not understand all of the risks involved.
+ Potential tax advantage
The potential tax advantage is another major driver behind the MLP resurgence. Most of the partnerships earnings may be offset by tax deductions, like depreciation and energy tax breaks. “Another key advantage of MLPs,” notes Dittler, “is that distributions are not taxed at dividend tax rates.”
Typically, the distributions received from an MLP are treated as a return of capital and are an adjustment to the investor’s cost basis. Let’s consider a hypothetical scenario that illustrates the difference between how a corporation and an MLP are taxed.
Assume you were to buy shares of a publicly traded corporation, XYZ Company. The company pays taxes on its profit, and then might distribute any income left over to shareholders. When the investors receive the distribution, they incur taxes on the payment. This combined effect is known as double taxation; XYZ’s profit is taxed at the company level, and then once again at the shareholder level if and when a distribution is received.
An MLP does not pay taxes at the entity level. Instead, the earnings are allocated to investors who are solely responsible for paying taxes on earnings of the MLP, to the extent not offset by deductions. The MLP will notify the unit holder of their tax liability share and possible deductions. As noted above, distributions are not subject to tax, but are an adjustment to the investor’s cost basis. After an investor has reduced their cost basis to zero, additional distributions are taxable. For 2012, those rates are currently as high as 15%, versus ordinary income tax rates which are 35% at the top bracket. Rates are scheduled to increase in 2013 unless Congress acts.
It is important that investors understand the tax reporting for master limited partnerships can be significantly more complex than was described here, and that they should consult their tax advisor to fully understand the implications of owning MLPs.
Potential tax advantages and high yield are just two of the upsides of MLPs. Other draws include exposure to growth in the productivity of U.S. oil and gas wells (which are the underlying assets in most MLPs), and tradability.
+ Exposure to U.S. oil and gas industry
Strong secular domestic trends could underpin energy-linked MLPs. The International Energy Agency (IEA) recently forecasted that the tremendous growth in domestic oil and gas productivity will make the U.S. the world’s biggest petroleum producer by 2020, surpassing Saudi Arabia. The IEA also expects the United States to be able to supply all of its domestic energy needs, and to be an energy exporter, by 2030. MLPs might be a well-positioned vehicle to capitalize on this trend.
MLPs can be bought and sold much like stocks, and are covered by a growing number of ETFs as well. If the demand and interest in MLPs continues to grow, as it has been, so too will the liquidity and availability of securities in this group. However, there are unique risks to gaining exposure to MLPs through ETFs, as well as ETNs, that should be considered before investing.
Investors should also be aware of the risks of MLPs. Among them: concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy and market risk. It is advisable to consider the suitability of MLPs, given your individual income needs and portfolio constraints.
Because MLPs are concentrated, for the most part, in the energy sector, they may not provide meaningful diversification benefits by themselves. Additionally, most public MLPs are comprised of a small number of oil and gas companies, and so there are risks, not only if energy prices decline, but also if individual partnerships experience operational or financial distress.
There is significant liquidity risk associated with MLPs because they are not traded as frequently as stocks or bonds. “While the MLP market has shown recent growth, it is still a small market relative to other asset classes,” Bewick points out. “The small size of the MLP market could afford the opportunity to exploit inefficiencies, but it also creates liquidity risks.”
MLPs may experience heightened trading volatility if credit markets were to seize up. Being that MLPs distribute most of their income to investors, they are usually left with little cash as a cushion in the event of market turbulence. “Capital markets all but shut down in 2008 and 2009, and MLPs displayed commensurate volatility,” Bewick says, “because they rely so heavily upon debt and equity markets to raise capital.”
- Tax complexity
There can also be a significant amount of paperwork involved with owning MLPs as there are increased tax reporting requirements.
MLP funds are organized as Subchapter "C" Corporations and are subject to U.S. federal income tax on taxable income at the corporate tax rate (currently as high as 35%), as well as state and local income taxes. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be tax-deferred return of capital, and for portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments. This deferred tax liability is reflected in the daily net asset value (NAV), and as a result the MLP fund's after-tax performance could differ significantly from the underlying assets, even if pre-tax performance is closely tracked.
The potential tax benefits from investing in MLPs depend on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation, then its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution to the fund, which could result in a reduction of the investment's value.
Moreover, with most income distributions, such as stock dividends, investors receive a Form 1099, along with their regular tax forms. MLP investors typically receive the more complicated Schedule K-1 form. The potential tax advantage that an investor receives depends on several factors, including their proportionate ownership share, tax basis, and the amount of depreciation that the MLP reports. Bewick adds, “If an MLP has operations in multiple states, then the investor may need to file a return with each state.”
Also, MLPs may not be appropriate investments for tax-advantaged accounts (i.e., 401(k), IRA) because of potential negative tax consequences (namely Unrelated Business Tax Income) for those types of accounts. Again, consult a tax advisor when considering purchasing MLPs, especially within tax-advantaged accounts.
- Fiscal policy and interest rates
There is also the legislative risk to consider. If Congress and President Obama pursue tax reform and long-term deficit reduction next year, many tax provisions may be addressed, including income tax rates, capital gains and dividend rates, and the tax treatment of pass-through entities. Longer-term, because the income component of MLPs has been desirable for some investors in this low bond yield environment, an eventual rise in interest rates might diminish their appeal.
MLPs are managed by a general partner, and the limited partners pay a fee for this service. In some cases, management expense fees can be relatively high. The MLP general partner decides what percentage of earnings is retained and paid out to the other partners. It’s in the general partner’s interest to grow the MLP’s earnings and increase distributions since that can justify them earning higher management fees.
Weigh the benefits and risks of MLPs
Are MLPs suitable for you? The very fact that many MLPs have performed so well in recent memory is one reason to consider if there is still value to be had. Moreover, not all MLPs are created equal. A particular MLP's revenue stream may be unproven and could carry significantly more risk than other traditional MLPs. It is crucially important to fully understand the underlying business before making an investment decision in MLPs.
However, current high yield, favorable tax treatment, the link to the booming U.S. energy industry, and tradability may continue to make MLPs attractive to investors. Weigh the pros and cons carefully, and consider consulting your tax advisor before you decide.
- Research MLPs by selecting Unit Trust Fund using the screener.
- Research the Fidelity® Strategic Income Fund (FSICX) and Fidelity® Strategic Real Return Fund (FSRRX).