Publicly traded partnerships—also known as Master Limited Partnerships or MLPs—represent an asset class with more than 100 names and over $500 billion in market cap. Their presence is undeniable, yet their form and function have accumulated a high degree of mystery in the investment community. Many investors’ interest in MLPs is driven by the potential for enhancing yield and return while deferring taxes due to their ability to generate non-cash deductions, such as depreciation expenses. But some of these perceived benefits may not be as enticing to investors when you look at the whole picture.
Dr. Marlena Lee, Vice President of Research at Dimensional Fund Advisors, describes MLPs in a recent article: “Unlike corporations, Master Limited Partnerships (MLPs) are not considered a taxable entity and do not pay taxes on earned income. Instead, MLP income is distributed to shareholders and is taxed at ordinary income marginal rates. This means that MLPs avoid the double taxation incurred by corporate dividends.
MLPs first appeared in 1981 and the number of MLPs continued to grow until the passage of the Revenue Act of 1987, which imposed stricter requirements for partnership taxation. After a two-decade decline, the MLPs made a comeback, with additional MLPs appearing from about 2005 on. Oil and gas MLPs make up the majority of this recent increase.”
According to a CPA firm in Austin, Texas, IRC 7704 allows publicly traded partnerships (that would otherwise be taxed as corporations) to stiff-arm the corporate income tax if 90% of their income is passive. The pitch to investors, then, is that return on investment is heightened by the avoidance of double taxation, and additionally, MLPs typically make quarterly dividends that are taxable at capital gains rates when the investment is sold.
What many investors fail to realize is that the mathematical basis for expected returns remains the same for all stocks, and this applies to MLPs as well. The difference in the business structure of an MLP will have more an effect on its price (higher) than a non-MLP business structure. For example, if a company switched from a corporation to an MLP, with no change in the underlying business, its tax rate would be lower and the stock price would receive a one-time upward adjustment but expected returns should be the same.
Essentially, investors pay more for a unique business structure, but the underlying expected return on the investment is no different from any other investment, good or bad. This begs the question, do investors make up for the higher price they are paying relative to other investments?
While MLPs typically make quarterly cash distributions to their investors, these monies are not returns on capital, but rather returns of capital. Only when the MLP investment is sold will these early cash distributions be factored into the overall taxable income equation from which yield can ultimately be determined.
Dr. Lee looked at returns of MLPs from 1985 to 2011. She found that despite the pitch by MLP providers, over longer periods, the higher distribution rates of MLPs do not necessarily mean they will have a higher total return than the market.
To summarize, investors should beware of being tempted by MLPs by assuming they will give them a better return than other investments.
Some Points To Remember When Considering MLPs
- Given that MLPs will not necessarily have a higher total return for investors, it makes sense to fall back to overall investment goals and strategy which includes considering commissions, fees, expenses and complexity.
- According to Dr. Lee, MLPs are heavily concentrated in natural resources, so a large allocation to MLPs can introduce idiosyncratic industry risk. Industry risk (like company, sector, country risk, etc.) is a gamble that may or may not reward investors. We prefer to have our clients only take risks that have always rewarded investors over time. Why take the industry risk if you might not be rewarded?
- One stated benefit is to hold MLPs for perpetuity so heirs receive a step up in basis. But, a step up in basis at death is not unique to MLPs, so how this can be considered a benefit unique to MLPs is a curiosity.
- Preferential tax treatment does not necessarily imply that MLPs offer a higher after-tax total return. A properly managed portfolio without MLPs can create tax benefits over time with strategies such as tax-loss harvesting.
- Just like other capital investments, if an MLP is not held for a year or longer, the income will end up being taxed at short-term capital gains rates (otherwise known as ordinary income rates).
- The complexities of tax reporting and the limited transparency of MLPs are good for Wall Street, but not so good for individual investors. Most investment professionals and most investors do not understand how MLPs really work.
If you are being pitched the benefits of MLPs as an investment, or you currently have MLPs in your investment portfolio, beware. We highly recommend you get a professional and objective analysis to weigh the costs versus benefits relative to alternative strategies. Contact us anytime for a professional review at 1-800-620-4232 or email@example.com
Morgan H. Smith Jr. IMBA CFP®, Partner, WorthPointe
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