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MLPs (Master Limited Partnerships) have become increasingly popular because of their yield and growth characteristics. Good yield and good growth. What's not to like? Well tax complexity for one. With MLPs you are not a stockholder, but a limited partner, also known as a unitholder.

The K-1

So what does that mean? Well first off, MLPs do not pay corporate taxes, but rather pass through the majority of their income and deductions to the holders of the limited partnership. So instead of receiving a 1099 from a corporation, as an MLP unitholder, you get the dreaded Schedule K-1, which must be filed with the IRS as part of your individual tax return. And, yes it will add complexity to your return. This complexity limits the appeal of MLPs among many investors.

For those who have learned to live with the K-1, MLPs can be very attractive investments. However the tax ramifications of buying, owning and selling MLPs are often not well understood. At the end of the day, the only thing that should matter to investors is the after-tax return, the amount you can put in your pocket and spend. In this article I will attempt to clarify how it all works, so you can make intelligent choices when investing in MLPs, especially in light of the potential changes to the tax laws in 2013.

Marriage

When you invest in an MLP, you should think of it in terms of marriage. That is, invest for the long haul. While MLPs can make excellent long-term partners, as with divorce, they can also be expensive when you decide to part ways. And as with marriage and divorce, the longer the relationship, the more expensive it will be. Let's look at the tax rules to understand why this is, beginning with dividends.

When you receive a dividend (technically a distribution) from an MLP, the income is not an ordinary qualified dividend as it would be from a company such as Exxon Mobil (NYSE:XOM). Rather it is a composite of regular income and return of capital. Return of capital is almost always the dominant component, often making up 85% or so of the total distribution. The K-1 defines this number exactly. So what is return of capital and why is this so?

MLPs don't distribute from profits the way most dividend-paying corporations do, but rather from the cash flow generated by the MLP's underlying assets. And those assets depreciate. They depreciate a lot. So ordinary income in an MLP is generally well south of cash flow, since depreciation reduces taxable operating income, but not actual cash flow. And in MLPs depreciation is generally big, given that they operate very capital intensive businesses.

Return of Capital

Return of capital is not taxable. And that is a fantastic thing. Let's say you buy 100 shares of an MLP trading at $100 that yields 6%, meaning you have invested $10,000 and will receive total annual distributions of $600. Next year, when you get the K-1, you notice that 85% (or $510) of the distribution was return of capital income and the remaining 15% was ordinary income ($90). You will pay ordinary income tax rates on that $90. Further, let's assume it is 2013, you are a big earner and the worst-case tax rates come to pass. This means you will pay 39.6%, plus 3.8% for Obama care for a total of 43.4% on the ordinary income or $39.06. On the return of capital you pay nothing. Total tax bill on $600 is the $39.06, resulting in an after-tax return of $560.94 or over 5.6%. Not too shabby. And if you hold the MLP, it's the same good story, year after year.

Basis Goes to Zero

There is one more little wrinkle to the married forever case. So to continue our example, for our $10,000 investment every year we receive $510 in return of capital, and every year that lowers our basis by $510. So our basis is lowered to $9,490 after the first year and $8,980 after the second year. Assuming nothing changes in the distribution, after 20 years of this, our basis hits less than zero. So what happens?

When your basis is exhausted, all subsequent return of capital is taxed at capital gains rates. Still not bad, even under the most onerous 2013 tax scenario. The return of capital tax rate is 23.8% vs. 43.4% for ordinary income. So in our little example, the $510 return of capital is reduced by $121.38 ($510 x 23.8%) to $388.62 after the capital gains tax is applied. Total return is now $388.62 plus the $50.94 from the after-tax ordinary income component ($90 taxed at 43.4%) or $439.56. So the new after-tax return going forward is just under 4.4%. Still not bad, and it takes almost 20 years for this to happen!

MLP Performance

Note in our example, we kept everything constant for illustrative purposes. In the real world MLPs generally increase their distributions over time and the stock price often increases correspondingly. Let's look at some data, starting with the 10 biggest MLPs by market cap. Note the healthy dividend increases over a five-year period.

(click to enlarge)

The next graph is MLP price appreciation of the top 5 MLPs by market cap relative to the S&P 500 over the last five years. The worst of the bunch, Williams Partners (NYSE:WPZ) still outperformed the S&P by 30% or so.

(click to enlarge)

Let's look at the same graph, but add dividends to the return. After all, MLPs are about yield.

(click to enlarge)

Boy, those dividends do add up. Our laggard Williams Partners is now 100% better than the S&P 500 over the five-year period. Our winner, Plains All American Pipeline (NYSE:PAA) is up 150% vs. the S&P 500. The big Kahuna of MLPs, Enterprise Products Partners (NYSE:EPD) checked in with a return 125% better than the S&P 500. That is why many investors will put up with the K-1. The performance is hard to ignore.

Divorce

So the time has come. You have had a long and productive relationship with your MLP, but have now decided to end it. Perhaps your MLP doesn't look so good to you anymore. There is another MLP that you find more attractive, and you want to divorce. Perhaps you just need/want the money for something else. Whatever the reason, let's consider the consequences.

Here is where it gets ugly, even without divorce lawyers. So using our example, you get the itch after seven years and decide to sell. Let's assume our MLP is still trading at $100 so there is no long-term capital gain or loss. Note, if there was a gain, the gain would be taxed at 23.8%. In those seven years, we have received $510 x 7 or $3570 in return of capital. Here is the bad news. That $3570 is called recapture (well named) and that is exactly what the IRS does. Recapture is taxed at ordinary income rates. The resultant tax bill for our high earner works out to $1549 per share ($3570 x 43.4%) on our $10,000 MLP investment. That is an expensive divorce, as we are losing over 15% of our original investment and future earning power by executing this sale, even though the price of the underlying security has not changed from our original purchase. You really have to want to get out to absorb a tax hit like that.

Till Death Do Us Part

The conclusion is clear. The recapture tax burden represents a significant loss of investable capital and future earning power and should be avoided whenever possible. Divorcing your MLP can be very expensive. Best to try to follow the MLP marriage vow of "till death do us part".

Look for installment #2 next week where I will cover some specific MLPs that may make good marriage material.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Stay Married To Your MLP - Divorce Is Expensive