Hello Taxes... Goodbye MLPs

Includes: KMI, LNCOQ
by: Reel Ken

"For every benefit you receive a tax is levied." Ralph Waldo Emerson

It seems to me that we're in an age where cliches and "sound-bites" have taken the place of research and analysis.

Just a few days ago, I was watching a financial network panel discussing year end planning. The moderators deferred to a very well-known "financial planning celeb." This "celeb" made the usual tax recommendations, including accelerating deductions such as charity, medical, prepaying local taxes and selling stock "losers."

Amazingly, and without taking a breath, the "celeb" then suggested accelerating income where possible and selling stocks with big gains to beat the impending tax increase.

Now, if any reader can't see the nonsense associated with a strategy of accelerating both deductions and income coupled with selling both losers and winners, then the balance of this article will be over your head.

I suspect that there will be renewed and increased interest in MLPs as a result of the new tax plan, and investors will most likely be drawn into them based upon the usual cliche or "sound-bite" as a tax shelter or tax deferral mechanism. So, let's replace that with analysis.

Now, let me be very clear, I'm discussing the TAX implications, not the investment implications of MLPs. This is especially relevant, as many of the MLPs (such as LINE and Kinder Morgan) offer corporate clones (LNCO) and (NYSE:KMI) in addition to the MLP structure. For convenience, I'll refer to the corporate structure as simply "stock."

Drilling down through all the complexity of the tax code, we arrive at the following tax differences between MLPs and stock:

1). Qualified dividends and long-term cap-gains on Stock are afforded favorable tax treatment. For 99% of investors, it will be 10% or 20% and for high earners (over $250,000), 23.8%. I would like to think the range for SA readers is 20% to 23.8%.

2) MLP distributions, representing return of capital (ROC), are tax-free when received. When the units are sold, these previously received tax-free distributions are "recaptured" at ordinary income rates. The maximum rate (including Medicare tax) is now 43.6%. The tax is graduated, and most investors would more likely be in the 33% range.

Now, one must keep in mind that it is only the cumulative distributions and dividends that differ in tax treatment. For instance, any growth above the recapture on the MLP and any growth on the stock alternative would both be subject to favorable capital gains taxation.

So, the analysis need only be directed at answering the following question... Is it better to receive tax deferred MLP distributions and then pay 33% to 43.6% on them when sold, or is it better to pay 20% to 23.8% yearly dividend taxation and no tax when sold?

The answer to this question involves two variables:

1) The reinvestment interest rate return on the distribution. Since most MLPs yield around 6.5%, I'll assume a DRIP at 6.5%, and

2) The number of years held. For this, I'll just calculate at 10 and 20 years. Other durations have similar results.

Assuming the distribution or dividend is $1,000 annually and is reinvested at 6.5%, the following chart shows the values of a tax deferred MLP distribution taxed on sale at 33% versus stock dividends taxed at 20% each year, leaving only $800 to reinvest, but with no taxes on sale.

One can clearly see that the Net After Tax Return on the Stock dividend is significantly greater (more than 20%) than the MLP distribution. If the investor is in the higher 43.6% bracket, the advantage is even more decisively towards the stock.

Keep in mind that this just compares the net after tax effect of the annual distributions/dividends, as the growth element is the same.

I have often heard pro-MLP devotees remark that they would hold the MLP until they die, thus benefiting themselves via tax deferred returns. Surely this is possible, but that may mean holding one particular investment for 20 years or more. Considering how few investments are actually held that long and all the intervening factors that may come into play, such a strategy may turn out to be low-probability.

For instance, I own both LINE and EPD, and have done so for many years. I am "tax-locked" into them, not wishing to pay the recapture tax in addition to sizable capital gains.

"Tax-lock" is not always bad. Even though held somewhat against my will, they continue to gain in value. But this growth value is diminished because of my hesitance to sell them. So, I ignore the market value and look at the income stream.

The more the market value goes up, the more willing I will be to pay the tax. If the market value doesn't increase, or decreases, my desire to save taxes may cost me other opportunities. This issue is not trivial, so give proper consideration to it when thinking you'll just hold forever.

Conclusion: Analysis contradicts "sound-bite" wisdom. MLPs, though potentially very good investments, represent a tax drag, not a tax advantage. Any thoughtful investor should take into account the extra tax cost associated with the MLP structure.

But let me emphasize and make it very clear that I'm not against MLPs from an investment standpoint. They can provide a nice income stream and many are very stable. This analysis is designed simply to shed light on the tax issues that actually take away some of their edge.

For those considering a company that offers both MLP and traditional structures, proper consideration should be given to the true after tax benefits when choosing.

Oh yes, lastly, this particular analysis isn't relevant if you're looking at an MLP in an IRA or ROTH, but I've "been there, done that" in previous articles.

Disclosure: I am long LINE, EPD. 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.

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