Personal Finance

Money Matters: Are master limited partnerships right for your portfolio?

Q. I’m sick of waiting for interest rates to rise on CDs and now I’m considering investing in income producing stocks. I’ve read about master limited partnerships. What are these and would they be a good addition to my retirement portfolio?

A. I’d need to know a lot more about your financial goals and existing portfolio before I’d be able to answer the last part of your question. Master limited partnerships (MLPs) may be a good addition to your portfolio but they are certainly not comparable to CDs from a risk standpoint. Depending on your risk tolerance and your other investment holdings, you may be better off waiting in cash or short-term CDs until CD interest rates are more appealing. You should be able to purchase a 12 month CD with a 1 percent to 1.2 percent interest rate. Not very exciting, but you have FDIC insurance and you won’t lose any money.

If you are OK with adding some risk to your portfolio, MLPs may be a good fit. The yield on MLPs are relatively high but the prices will fluctuate. MLPs are limited by US Code and only enterprises that engage in certain businesses can be structured as MLPs. These businesses tend to be focused either on the extraction and/or transportation of natural resources, such as petroleum, natural gas and crude oil. If you already hold natural resource stocks or mutual funds in your portfolio, adding MLPs may result in too much exposure to this asset class. Also, if you are looking for investments within an IRA or other tax sheltered investment account you may not want to buy MLPs due to their taxation which I’ll explain below.

MLPs have general partners who manage the partnership and limited partners who own the rest of the partnership not as shares of stock but as units. The general partners manage the day to day operations and the limited partners have no involvement in the operations of the partnership. General partnership units are usually not publically traded and limited partnership units are publicly traded. The limited partnership units are easy to buy and sell as they trade just like a share of stock on the stock exchanges. It is common for the general partner to own 2 percent of the partnership and they increase ownership by purchasing limited-partner units.

Defer the tax

MLPs don’t pay dividends but they have distributions. The MLP may be structured so that the general partner has an incentive to increase the cash distributions to the limited partners. This doesn’t always translate to more cash available for the limited partners so a review of the partnerships agreement with the general partner is advisable. Example: a general partner may get 2 percent of quarterly distributions if they are a certain amount and for amounts above that they can receive a higher percentage. Some agreements allow for the general partner to receive 50 percent of the distributions.

Under current tax law, MLPs avoid the double taxation to which corporations are subject. A corporation must pay taxes on earnings at the corporate level and when shareholders receive dividends those earnings are taxed again. With MLPs there is only tax paid on distributions. To qualify for this more favorable tax treatment, MLPs must pay out a very high percentage of their cash to the limited partners. These cash distributions often exceed the partnership’s income. When this occurs, the portion exceeding partnership income is deemed return of capital to the limited partner and not immediately taxable.

This provides a method to enjoy income now and defer the tax. The return of capital reduces your cost basis per unit and when the units are sold they are taxed at the currently more favorable capital gains rate rather than at ordinary income tax rates. Distributions from MLPs held in a tax deferred account such as an IRA are often subject to something called unrelated business taxable income (UBTI). There is a small exemption but it is best to avoid holding individual MLPs in tax deferred accounts. You can avoid the UBTI problem by buying mutual funds and exchange traded funds that own MLPs within your IRAs and retirement accounts.