Avoiding master limited partnerships' tax hassles

Last Modified: Saturday, March 2, 2013 at 4:59 p.m.

Master limited partnerships (MLPs) have historically been one of my more successful investments. Unfortunately, investing in them can create significant tax complications and record-keeping hassles.

Now, however, both the companies themselves and the broad investment community have created ways to get most, if not all, of the benefits of direct investment in MLPs without these impediments.

Before looking at the specific investments, let's review the basics of MLPs.

MLPs are limited partnerships that trade on major exchanges just like the stocks of ordinary corporations. Their business is usually related to the transport and storage of crude oil and natural gas. To be an MLP, a firm must satisfy stringent IRS requirements, including that 90 percent of the firm's income comes from businesses like those just mentioned.

MLPs are required to make quarterly distributions. Since they are partnerships, they avoid corporate income taxes at both the federal and state level. Thus, their distributions tend to be large. Over the last decade, they have had total returns that averaged 10 percent annually, many times the S&P 500's. Of that, about 7 percent came from distributions.

Unfortunately, taxes are not avoided. The income stream is still taxed once, to the individual investor. However, a significant part of the distribution is a tax-deferred return of capital. This means that the investor can avoid paying taxes on that part of the distribution until the MLP is sold.

These benefits do not come for "free."

Unlike corporations that issue 1099 forms, MLPs issue K-1's and have until March 15 to do so, as opposed to Jan. 31 for 1099s. Additionally, K-1's are more complex than 1099s. Some large investors may also be required to pay state taxes in states in which the MLP operates. Additionally, record keeping is complex because each distribution's return of capital reduces the cost basis of the investment, so the investor must keep track of these, perhaps for many years.

Three MLPs have devised attractive ways for an investor to invest in them without these complications.

Kinder Morgan Energy Partners (ticker: KMP) and Enbridge Energy Partners (EEP) have created related stocks, Kinder Morgan Management (KMR) and Enbridge Energy Management (EEQ) that pay distributions only in stock. These dividends in stock are paid at the same rate as the cash dividends of their related companies, but the IRS does not tax these until they are sold.

Linn Energy (LINE) has adopted a different strategy. It has created a companion company, Linn Co. (LNCO). Each share of LNCO is backed by one share of LINN. This means that LNCO should pay the same dividend as LINE after a deduction for LNCO's corporate tax. What this means is that the shares of LINN pay a distribution of $2.90 and the shares of LNCO pay $2.84.

The 6 cents buys the investor a 1099 rather than a K-1 and should avoid record keeping hassles. The taxability of the LNCO dividend is still uncertain; however, the full dividend is unlikely to be taxable as ordinary income.

The investment community has created other ways to avoid MLP hassles.

One is MLP mutual funds. IRS regulations do not, however, permit MLP mutual funds to be organized like a traditional mutual fund; they must be ordinary corporations. This means they do pay taxes on MLP distributions, reducing the investor's dividend. Additionally, there will be management fees and possibly front-end sales charges.

There are also MLP exchange-traded funds and closed-end funds that avoid, at a cost, the hassles of direct investment in MLPs.

Finally, there are exchange traded notes (ETNs).

These are debt securities, similar to bonds, whose distributions are fully taxable as opposed to tax-advantaged dividends. In the case of MLP ETNs, the distribution-rate is equal to the distributions of an index composed of MLPs, minus a management fee of less than 1 percent. These also do away with the K-1's and record keeping. But the investor assumes default risk, because these are the unsecured debt of banks.


This story appeared in print on page D12


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