Q: Master Limited Partnerships are just too complicated from a tax perspective to buy, even in a retirement account. Do you agree?
A: Low interest rates have sparked a surge in interest in master limited partnerships, or MLPs, by those searching for high income. Usually, MLPs are companies that own and operate pipelines, primarily for natural gas and oil. But unlike traditional corporations, MLPs are organized as partnerships. They retain no earnings and pay no taxes. Instead, they pay out all their profits to their partners, known as unit holders, as regular distributions. Units trade on stock exchanges like any shares.
On average, MLPs pay unit holders a yield of 6.6%, as of Dec. 1. With 10-year Treasurys yielding about 3%, more investors have flocked to MLPs, sending unit prices higher.
Here’s a catch, though: The quarterly distributions aren’t dividends. They’re an investor’s share of the partnerships’ earnings, as well as the return of an investor’s capital. As such, their tax treatment is more complex than the treatment of dividends of common shares.
The return of principal is tax-free, while the income from the partnership is taxed at the investor’s ordinary tax rate. If the MLP operates in a number of states, an investor might have to file nonresident tax returns to report income to those states, though an investment of less than $10,000 likely will allow an investor to avoid such a filing, says Jill Lervold, a certified public accountant at the accounting firm Eichstaedt & Lervold LLP in San Francisco. MLPs’ investor-relations departments generally provide helpful tax information, says Ms. Lervold.
Placing an MLP in a retirement account can cause other headaches. Retirement plans pay federal income tax on “unrelated business taxable income,” a category that MLP operating income falls under. So if a retirement account earns more than $1,000, an investor must file a Form 990T.
The easiest way to deal with the complexity is to hire a tax preparer, but tax-preparation software also can deal with MLP distributions. One strategy to avoid the tax headaches is to buy closed-end funds, ETFs or exchange-traded notes that bet on MLPs. Taxes for these investments usually are paid at the company level, so investors only need to worry about taxes on any capital gains or dividends. These vehicles also provide diversification—instead of owning one MLP an investor can have access to a bucket of them. The problem is these vehicles all charge management fees, which can be 1% or more.
“The aggravation is a small price to pay for an attractive cash yield,” argues Helen Wu, of the accounting firm J. Arthur Greenfield & Co. in Los Angeles. “Ignore the tax complexity and focus on the financial merits of the investment.”
But Darren Pollock, who helps run Cheviot Value Management LLC, an investment firm in Santa Monica, Calif., argues that many MLPs have become too expensive because they have outperformed the overall stock market in the past couple of years.