MLPs are among the more popular topics on Seeking Alpha. This is not surprising given the low yield environment into which Chairman Bernanke has thrust us and the relatively high yields of MLPs. The ALPS Alerian MLP ETF is currently yielding around 6.0% (NYSEARCA:AMLP), a far cry from investment grade bond yields, dividend growth yields and certainly well above Treasuries. Yes, I know that these other asset classes do not present an apples to apples comparison, but are considerations for investors seeking yield.
I favor individual MLPs as opposed to a fund or ETF approach but this is where the analysis becomes more intricate. Dividends from an MLP are reported on a K-1 and will likely complicate your annual tax return beyond the typical forms. Although MLPs can be a good investment for many different types of investors, there is a particular situation in which the tax benefits are essentially doubled.
Let's take the example of an MLP, namely Kinder Morgan Partners (NYSE:KMP) one of the largest pipeline MLPs. We will assume that our investor, Bob, purchased 100 shares of KMP on January 2, 2003 at the price of $36.00 per share. Although some of the quarterly distributions are partially taxable, for simplicity we will assume that all distributions are return of capital up to 100% (you can't recover more than 100% of your initial investment as capital). Cumulative dividends would have totaled $36.92 or 102.5% of Bob's original investment received in dividends over ten years. The current yield on cost (although I find that particular metric entirely useless in evaluating investments) would be 14% per year. These are all certainly very exciting numbers for any investor.
Now that the ten years have passed, let us look at two options for the shares. First, we can plan to sell the shares after the ten years (or at any earlier time). Our taxes will be determined by the sales price, less the return of capital we have already received, which is 100%. We will be taxed on 100% of the sales proceeds. While certainly not exciting, at least we received our original investment back and are now selling for the current price of over $80.00 per share. The problem with this scenario is that the gain is not taxed at long-term, capital gains rates but is taxed as ordinary income. In high tax states, this could results in a tax bill of in excess of 50% of proceed, hardly an enticing prospect.
Now we can discuss the "hidden benefit" of MLP investing. This is no secret but is not appreciated by many investors and provides a second benefit to the "tax free" distributions. MLPs are a great estate planning tool. Let's take the above hypothetical and assume that Bob dies after 10 years (sorry Bob). He will have received back his entire original investment back free of taxes and his heirs will benefit from the step up in basis and inherit the shares with a cost basis as of the date of death. Bob's heirs can then begin to take the tax free income again on 100% of the value of the property as of the date of death. If you're wondering, this can continue generation after generation and create quite a hereditary income stream.
As always, when considering any tax planning strategy it is imperative that you consult with your tax and investment professional but for those of you considering an MLP investment for income, this may just provide one additional benefit to your calculations.