Q. Several months ago you wrote about master limited partnerships but I didn’t buy any and now I’m wondering if I should. It seems like they have been hammered in this market. Could you explain why and if you think they are a good buy now? I was planning on buying them in my roll-over IRA but I seem to remember you said not to buy in a retirement account but I can’t remember why. Please explain why and a little more about this type of investment.
A. Master limited partnerships (MLPs) may be a good buy now but there is no guarantee they’ve reached bottom. Some may even wind up in bankruptcy. The third quarter was the worst performance quarter since the inception of this asset class in 1987. The yield on MLPs are relatively high but as we have seen, the prices will fluctuate. MLPs are limited by U.S. 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. Exploration & Production and Energy Services MLPs are greatly impacted by lower oil prices. Infrastructure or midstream (pipelines, storage terminals) MLPs are impacted by lower oil prices but to a lesser extent. The lower oil and natural gas prices have brought the stock price of almost all MLPs down.
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 publically 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.
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.
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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.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624