Confusion and misunderstanding provides opportunities for people who are willing to really make the effort to dig into the detail and learn the fundamentals of difficult topics. Such as a befuddled 7th grader whose eyes glaze over once the math teacher first broaches the subject of algebra, many investors shy from Master Limited Partnerships because they do not fit standard for stock investments, have yields that are “too much,” are not measured by the same metrics as other equities, might not be befitting IRAs, and generally are “more difficult” to understand than their other investments. However, for anyone prepared to take some time to examine a bit, they will see that the entire world of MLPs is not all that complicated and can provide a wonderful chance for a long term steady and growing income.
First of all, what’s a Master Limited Partnership? Master Limited Partnerships were established within the US Tax Code allow smaller investors to participate in operations with very expensive at the start costs such as for example oil and gas pipelines that might be out of grab the typical investor without such a partnership arrangement. Companies that choose to work as MLPs are generally large, slow growing and stable and usually have a monopoly within the territory they operate. The assets generally produce a constant cash flow, but growth is slow and limited to purchases of like facilities or new construction. MLPs don’t pay any corporate taxes, (often yielding higher returns as a result), rather income goes right to the system holders pro rated by the number of units they hold, and the system holder is taxed at the individual’s tax rate. Each unit holder is just a limited partner whilst the operation of the business enterprise is handled by the general partner.
Not every company can qualify as an MLP. First the company must earn 90% or maybe more of its income from natural resources (energy, mining, timber), minerals, commodities, real estate, real estate rents, or gains from dividends and interest. However, most MLPs currently come in the power area, specifically in oil products pipelines and natural gas pipelines. Generally oil product pipeline MLPs receive regulated fees for the transportation of product and are paid on volume unrelated to the price of the product being transported. This tends to make them more stable. Natural gas pipeline operators also frequently run the gas gathering function as well gives them exposure to the fluctuations in natural gas pricing. Many gas MLPs reduce steadily the impact of price changes by hedging thereby establishing an even more predictable cash flow.
MLPs make quarterly distributions which seem much like stock dividends however they are quite different. Typically a quarterly distribution is classified as partially net income, and partially a return of capital (in the entire world of MLPs this return of capital is another term for depreciation or a depletion allowance). Generally, the Return of Capital represents the lion’s share of the distribution. The income percentage of the distribution is taxed at the individual’s normal tax rate whilst the return of capital segment reduces the fee basis. Which means that you don’t pay any taxes on the majority of the distribution until such time as you sell the units. In a typical taxable account this makes MLPs perfect for both long haul investors and people that plan on leaving their units with their heirs.
In an IRA, or other tax deferred accounts, there is one additional complication. That’s, the smaller segment of the distribution that is treated as net income is How Much Gain Reduction Should You Use On The Master Limiter? classified as UBTI (Unrelated Business Taxable Income) and if this portion exceeds $1000 annually it is at the mercy of income tax even in a tax deferred account, such as for example an IRA, forcing the IRA to file a tax return. This dilemma is non existent for the typical investor where in actuality the UBTI will generally fall below the $1000 barrier. For investors with hundreds of a large number of dollars invested in MLPs in their IRAs, UBTI can be a more important factor. For individuals who are unsure it is essential to seek tax advice from the CPA or other tax specialist.
Evaluating an MLP is unique of evaluating a typical stock. Because of the huge outlays in capital equipment, and resultant typically large depreciation expenses, the normal earnings metrics are not befitting evaluating an MLP. Distributable cash flow is the most crucial single element in evaluating if an MLP is suitable for you. It’s the foundation for paying the quarterly distributions and provides cash for future expansion. It is essential to determine how consistent the distributable cash flow has been, and if it’s grown. As an example, Kinder Morgan Energy Partners, one of the finest known MLPs paid $0.475 per quarter in 2001, and only recently announced so it is likely to be paying $1.10 per quarter in 2010 up from $1.05 per quarter in 2009. It’s this sort of consistent growth in distributions which have made MLPs a well liked of the more sophisticated yield investor.