published Wednesday, October 19th, 2011

Personal Finance: Pipeline partnership stocks worth a look

By Chris Hopkins

Stock investors have been buffeted by volatility this year, and for income investors the landscape has been especially exiguous. Safe investments are generating close to zero, but reaching for yield in riskier assets can be a dangerous game.

One place to look for higher cash flow with less than market risk is underground. Specifically, the 1.5 million miles of oil and gas pipelines that crisscross the United States, gathering petroleum products at the port or the wellhead and moving them to the refinery and on to the consumer. This hidden web of pipes, tanks and pumps performs an essential role in delivering energy to industry, utilities and homes safely and efficiently.

The opportunity for income-oriented investors resides in the structure of these companies. While they trade on the major exchanges like conventional stocks, these entities are often structured as master limited partnerships or MLPs (sometimes called publicly traded partnerships).

MLPs are examples of a special class of corporate structure known as a pass-through entity. In exchange for the obligation to pass through at least 90 percent of net income to unitholders (shareholders), the company is exempt from corporate income taxes.

For the unitholder, distributions of cash from the MLP are attractive relative to other dividend-paying stocks. But higher yield is just the beginning; for investors holding the securities in taxable accounts, a significant proportion of the cash distributions are frequently classified as capital distributions and not as taxable income in the current year.

Holders pay tax on the fraction considered profits, but the rest of the payout is treated as a return of principal, taxed as a long-term capital gain at the time of sale (presumably after at least one year).

One significant inconvenience is the method of tax reporting: MLP holders receive a K-1 partnership return instead of a form 1099, and the tax return can be a bit more complex. However, tax preparers generally are well acquainted with these vehicles, and even TurboTax has provisions for reporting limited partnership distributions.

MLPs may be held in retirement accounts; however, there are additional complications. Owing to the specific tax characteristics of these entities, it is possible for units held in IRAs to generate taxable income, although the likelihood is small and any tax owed is not considered a taxable distribution from the IRA.

In addition to the attractive income potential and favorable tax treatment, pipeline MPLs tend to be somewhat less volatile over time than the stock market. These entities often sell off when energy stocks fall, but have traditionally recovered their value more rapidly.

Many of these firms have long-term contracts in place that guarantee a significant portion of the fee revenue from their customers regardless of the actual volumes transported. While all stocks carry risk, these vehicles are historically less correlated to the overall market over time.

It is estimated that the U.S. will require an additional $200 billion in energy storage and transportation infrastructure investment by 2030. Tapping into the pipelines could help to pump up your portfolio.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com.

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