Personal Finance: Master Limited Partnerships go mainstream

Personal Finance: Master Limited Partnerships go mainstream

September 3rd, 2014 by Dave Flessner in Business Diary

Chris Hopkins

Chris Hopkins

Photo by Patrick Smith /Times Free Press.

In a world of depressingly low interest rates, many investors have discovered Master Limited Partnerships as a relatively high-yielding alternative. While MLPs can play a valuable role in a well balanced portfolio, they must be understood and monitored to minimize unpleasant surprises.

MLPs differ from other publicly traded stocks in their structure and tax treatment. As the name suggests, these companies are limited partnerships, a form of business organization that passes profits and losses as well as cash distributions directly through to shareholders, avoiding double taxation at the corporate level. This class of publicly traded limited partnership is open to all comers via listing on stock exchanges, allowing individual investors to conveniently buy and sell interests.

Shareholders in these partnerships are called "unitholders," whose losses are limited to their investment (in contrast to the General Partner whose liability is unlimited). Unlike common stocks, shares in MLPs carry no voting rights.

The most significant difference for investors is the manner in which taxes are reported and assessed. Most MLPs issue a tax document called a schedule K-1 rather than the form 1099 common for other stock transactions. The addition of K-1s can complicate and possibly delay preparation of your tax return, but should not prevent your consideration of these investments if otherwise appropriate.

The first publicly traded MLP debuted in 1981, and by 1987 over 100 additional offerings had emerged seeking to avoid federal taxation. This led Congress to restrict the use of the structure to a narrow band of corporate activities, namely energy, natural resources and certain real estate activities. If at least 90 percent of a company's gross income derives from these activities, the firm qualifies to organize as an MLP.

Since these investments are required to pass through most of their distributable cash flows, they tend to offer attractive income to unitholders. And since they provide a convenient entree into the North American energy infrastructure expansion, MLPs as a class are likely to remain attractive for a considerable time.

Of course, as with any investment, the devil is in the details. Many investors are familiar with so-called midstream MLPs that provide transportation and storage of oil, gas and refined products. These companies operate pipelines, storage facilities and terminals that are essential to the efficient movement of energy. Their revenue is typically fee-based subject to long-term contracts and therefore their distributions are often (but not always) relatively stable.

So-called upstream partnerships extract resources like oil and gas and typically pay out higher yields, but carry more risk as they are subject to the vicissitudes of energy prices. Other MLPs engage in disparate activities like coal production, propane retailing, shipping and refining. Each carries its own unique risks and rewards and should be carefully researched.

One additional complication arises if MLPs are held in retirement accounts like IRAs. Due to their partnership structure, they can occasionally (but infrequently) create tax liabilities inside an IRA. It is the responsibility of the custodian (your broker) to assess and report any tax liability, but you must submit your K-1s to the custodian each year for any partnerships in your IRA.

It is especially important to monitor for any risk of distribution cuts that would reduce your projected income and cause the price to drop. Furthermore, in addition to company-specific risks, MLPs are subject to volatility due to interest rate fluctuations like any other high-yielding dividend stock.

MLPs have proven to be highly successful vehicles for capitalizing the essential U.S. energy infrastructure, and with adequate due diligence may provide income investors with a compelling investment alternative.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager at Barnett & Co. in Chattanooga.