Looking at the Concept of MLPs for Dividend Growth Within Your Portfolio 12 comments
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This article was originally published on The DIV-net on May 7, 2009
I continue to believe that every asset class has its significance and its own importance. Every asset class has a role to play in investment portfolios. However, individual investors need to understand these factors in the context of their own portfolios. Being a do-it-yourself investor, I like to ignore the market noise and understand how any asset class will affect my portfolio objectives. In earlier posts, I have discussed about my investing approach with respect to commodity asset class, international developed/emerging asset class, and the investment vehicles that I like to use.
Master Limited Partnerships (MLP) are another asset class that provides relatively higher yields than compared to commonly known dividends. MLPs were established by congressional act in mid-to-late 1980s to increase investments in energy and natural resource projects. If not always, then in most of cases, there are the companies that are engages in exploration, production, mining, processing, refining, marketing or transportation of mineral and natural resources. These natural resources could be oil, coal, propane, natural gas, timber, etc. Among other, MLP asset class has three significant differences when compared to corporate equities. These differences are:
Cash Distribution (and not cash dividends): The cash paid by MLPs to it’s until holders is known as distributions (and not dividends) which come from “distributable cash flow”. The distributable cash flow consists of MLPs entire cash flow less expenses such as operations, maintenance, and debt servicing. After looking at about five to eight MLPs, it was difficult for me to understand how companies determine distributable cash flow. There was no consistency across multiple MLPs. This lack of consistency makes it difficult to understand its ability to continually pay and raise distribution. For example, the cash flow can be increased by selling partnerships units and/or taking debts. In addition, distribution is increased without any increase is operational cash flow (or operational income?). It is not clear to me how the distributions are continually increased.
Tax Structure: MLPs operate as partnerships (instead of corporations). Therefore, they pass on their income to their unit holders. In this way, collectively the partnership does not pay tax. This is called favorable taxation. There is another school of thought that says since MLPs do not pay tax, there is more cash available for distribution. However, the tax is supposed to be paid at individual partner or unit holder. For the first few years, individual units do not pay any tax because the distribution is termed as “return of capital”. Every year this “return of capital” reduces unit holder’s cost basis. At certain point in time in future, this cost basis will become zero, and then cash distribution becomes taxable as current income. In addition, any sale of units will be taxed as capital gain/loss tax structure.
Growth: MLPs are required to pay out a significant portion of their earnings to unit holders (or partners) so that they can qualify for their favorable tax treatment. They cannot retain large portion of their earnings. Therefore, the only way to grow is to either issue new additional equity or use debt funding. Increasing equity dilutes existing unit holdings (i.e. no growth) and debt funding has potential to reduce distribution (service costs).
The market performance of MLPs as an asset class can be measured by Alerian BearLinx MLP Select Index ETN (BSR). It tracks the Alerian MLP Index. I did not like the structure of this index fund, because the index is top heavy with top 10 MLPs occupying more than 50% of the its assets. In addition, there are many other closed-end funds that are based on MLPs.
MLPs that caught my attention were the ones that are known as mover and transporters of oil, natural gas, etc., These MLPs act as transporters and their earnings come from renting their infrastructure for movement. They are not exposed to volatility of commodity pricing. In addition, they are able to raise their pricing to track inflation, and hence provide long term inflation hedge. Pipeline MLPs bring in earnings (or cash flow) from their existing infrastructure. At the same time, they are expanding their infrastructure using new equity or new debt.
To summarize…
MLP industry sector is part of energy infrastructure, and hence I believe pipeline MLPs as a asset class may have longer term promise. I plan of taking a dip and make a small seed investments. This seed investment will allow me to continuously watch, read more, and follow happenings in MLP industry sector.
- In short-to-intermediate term, I do not believe they are good high quality investments. Therefore, I will be making a very small allocation in my dividend growth portfolio. The distribution yield may be high, but I believe the high yield is an indicator of high risk of investments in MLP sector. One of the major drivers for high yield has been the high payout factor. MLPs do not retain major portion of the earnings. The growth and capital needs are funded by new equity or borrowed cash (i.e. more debt). In the recent past, the credit environment was able to support this business model. How long will this continue?
- In is only in last 10 to 12 years that MLPs have become more prominent and investable for common individuals. The promised benefits of tax deference and other factors are perhaps, still not realized. In majority of the cased, they are most likely still paper benefits.
Dividend growth investing is a long term process. Borrowing from future (tax deferred, debt funding) and showing rosy present (high yield, no tax) is something that is never sustainable. I consider this present performance which is borrowed from future.
Disclosure: Long EEP
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It should be clear that an MLP's high yield is not an indication of high risk, but of a tax treatment and cash flow structure quite different from that of stocks.
1) First, the author has confused the MLP's taxable income with their cash distributiond. MLPs, like other partnerships, do not pay tax at the partnership level--but tax is paid on their income. All items that go into calculating taxable income--income, gains, losses, etc.--flow through the partnership and are allocated proportionately among the partners (i.e., the shareholders), each of whom nets them out and pays tax on his/her share of net partnership income at his/her own rate. This occurs on paper and has nothing to do with the cash distribution. Thus, it is not true that individuals pay no taxes because of the distributions, although the passthrough of losses and deductions does reduce taxable income quite a bit.
2) The distributions are something entirely different from the partner's share of taxable partnership income. As the article correctly states, they are considered a tax deferred return of capital, lowering the partner's basis in his partnership units and taxed upon sale of the units. Typically, the partner's share of taxable income in any year is far less than the tax deferred cash distributions.
3) Distributable cash flow is expressed in various ways, but is basically equal to earnings plus depreciation or depletion (because these are tax deductions only and do not affect the partnership's actual cash flow), minus "maintenance cap ex"--the cash needed to maintain the partnership's assets. MLPs do not necessarily pay out all their dcf--many have a "coverage ratio" (dcf/distributions) of more than 1.0, and like any well managed company will reserve the cash they need for business operations.
4) Finally, MLPs are NOT required to pay out their earnings in distributions to maintain their tax treatment. Their ability to maintain partnership tax treatment depends on earning certain tyes of income--90% of their income must come from (to summarize) natural resources activities, real estate rents or gain from selling real estate, interest, dividends, or commodities. As long as they meet this income requirement they can pay out zero cents in distributions (which some do) and their tax status will be fine.
I would urge anyone interested in learning more about MLPs to go to the website of the National Association of Publicly Traded Partnerships (naptp.org) to get some solid information.
--don't buy MLPs in a tax deferred account like an IRA or you'll be hit with the dreaded UBTI tax.
--be aware of the fact that the general partner of MLPs earns a so- called "incentive distribution" that can be as much as 50% of the partnership's cash flow. In effect, the MLP investors put up 100% of the capital for 50% of the return. To their credit, some MLPs like Enterprise Products (EPD) and TC Pipelines (TCLP) have limited their take to 25%. A step in the right direction. (this writer owns units of EPD).
--be aware that you'll receive a K-1 tax form that will complicate your tax life. If you use a paid preparer, you'll pay a little more for the extra paperwork. If you use a software program like TurboTax, you'll need to purchase their top-of-the-line product, TurboTax "Premier" to handle the K-1 information.
Notwithstanding these caveats, my MLP holdings held up very well during the recent market meltdown, and distributions held steady or even increased. Any port in a storm!
I wonder if the K-1 issues that have been posted here are from past years, possibly the tax preparation industry has caught up and made it alot easier.
On May 21 09:37 AM Uncle Pie wrote:
> Other points to consider:
> --don't buy MLPs in a tax deferred account like an IRA or you'll
> be hit with the dreaded UBTI tax.
> --be aware of the fact that the general partner of MLPs earns a so-
> called "incentive distribution" that can be as much as 50% of the
> partnership's cash flow. In effect, the MLP investors put up 100%
> of the capital for 50% of the return. To their credit, some MLPs
> like Enterprise Products (seekingalpha.com/symbo...) and
> TC Pipelines (seekingalpha.com/symbo...) have limited their
> take to 25%. A step in the right direction. (this writer owns units
> of EPD).
> --be aware that you'll receive a K-1 tax form that will complicate
> your tax life. If you use a paid preparer, you'll pay a little more
> for the extra paperwork. If you use a software program like TurboTax,
> you'll need to purchase their top-of-the-line product, TurboTax "Premier"
> to handle the K-1 information.
> Notwithstanding these caveats, my MLP holdings held up very well
> during the recent market meltdown, and distributions held steady
> or even increased. Any port in a storm!
If Uncle Sam's tax is higher, then there is still a tax advantage to holding MLP's in tax-deferred accounts.
On May 21 09:37 AM Uncle Pie wrote:
> Other points to consider:
> --don't buy MLPs in a tax deferred account like an IRA or you'll
> be hit with the dreaded UBTI tax.
> --be aware of the fact that the general partner of MLPs earns a so-
> called "incentive distribution" that can be as much as 50% of the
> partnership's cash flow. In effect, the MLP investors put up 100%
> of the capital for 50% of the return. To their credit, some MLPs
> like Enterprise Products (seekingalpha.com/symbo...) and
> TC Pipelines (seekingalpha.com/symbo...) have limited their
> take to 25%. A step in the right direction. (this writer owns units
> of EPD).
> --be aware that you'll receive a K-1 tax form that will complicate
> your tax life. If you use a paid preparer, you'll pay a little more
> for the extra paperwork. If you use a software program like TurboTax,
> you'll need to purchase their top-of-the-line product, TurboTax "Premier"
> to handle the K-1 information.
> Notwithstanding these caveats, my MLP holdings held up very well
> during the recent market meltdown, and distributions held steady
> or even increased. Any port in a storm!
On May 20 09:00 PM Mary@NAPTP wrote:
> As the executive director of the MLPs' trade association , I have
> to agree with Mr. Young that this article shows a poor understanding
> of MLPs, and that the author should have educated himself before
> writing about them. Allow me to clear up some of the confusion.
>
> 1) First, the author has confused the MLP's taxable income with
> their cash distributiond. MLPs, like other partnerships, do not
> pay tax at the partnership level--but tax is paid on their income.
> All items that go into calculating taxable income--income, gains,
> losses, etc.--flow through the partnership and are allocated proportionately
> among the partners (i.e., the shareholders), each of whom nets them
> out and pays tax on his/her share of net partnership income at his/her
> own rate. This occurs on paper and has nothing to do with the cash
> distribution. Thus, it is not true that individuals pay no taxes
> because of the distributions, although the passthrough of losses
> and deductions does reduce taxable income quite a bit.
> 2) The distributions are something entirely different from the partner's
> share of taxable partnership income. As the article correctly states,
> they are considered a tax deferred return of capital, lowering the
> partner's basis in his partnership units and taxed upon sale of the
> units. Typically, the partner's share of taxable income in any year
> is far less than the tax deferred cash distributions.
>
> 3) Distributable cash flow is expressed in various ways, but is basically
> equal to earnings plus depreciation or depletion (because these are
> tax deductions only and do not affect the partnership's actual cash
> flow), minus "maintenance cap ex"--the cash needed to maintain the
> partnership's assets. MLPs do not necessarily pay out all their
> dcf--many have a "coverage ratio" (dcf/distributions) of more than
> 1.0, and like any well managed company will reserve the cash they
> need for business operations.
> 4) Finally, MLPs are NOT required to pay out their earnings in distributions
> to maintain their tax treatment. Their ability to maintain partnership
> tax treatment depends on earning certain tyes of income--90% of their
> income must come from (to summarize) natural resources activities,
> real estate rents or gain from selling real estate, interest, dividends,
> or commodities. As long as they meet this income requirement they
> can pay out zero cents in distributions (which some do) and their
> tax status will be fine.
> I would urge anyone interested in learning more about MLPs to go
> to the website of the National Association of Publicly Traded Partnerships
> (naptp.org) to get some solid information.
On May 21 10:18 AM Lightway wrote:
> I can confirm Turbotax Premier will handle the K-1, since I used
> it this year to handle a K-1 and it was extremely easy. You literally
> fill in about 3 boxes per K-1 and that's pretty much it.
>
> I wonder if the K-1 issues that have been posted here are from past
> years, possibly the tax preparation industry has caught up and made
> it alot easier.
On May 20 08:02 PM Alan Young wrote:
> With all due respect, perhaps it would be better, in the future,
> to learn how something works instead of publishing articles that
> list a lot of things you don't understand.... and then reaching a
> conclusion anyway?
>
> It should be clear that an MLP's high yield is not an indication
> of high risk, but of a tax treatment and cash flow structure quite
> different from that of stocks.
It all can be boiled down to this: you do pay tax on your share of the partnership's (MLP's) net income, which you know based on the information it sends you (the K-1). You don't pay tax on the cash distributions until you sell your shares. Usually your cash distribution is a lot more than the income you pay tax on. You don't need to worry about how an MLP calculates its "distributable cash flow," as long as it's enough to support the distributions, which any research report will tell you. And contrary to what the articles said, MLPs aren't required by the tax laws to pay distributions. They do it because that's how they attract investors. I'd be happy to answer any questions and will do my utmost to use standard English.
On May 21 03:55 PM moneypenny wrote:
> nice use of financial terms to make it even more complex. and nice
> education too. keep it up! BTW - I did not understand what you said,
> and I do not intend to do PhD that I have to read your website.
>
Pipeline MLPs and their General Partners, that are also MLPs, may be the best risk/reward long term investment the stock market offers. I recently put a mid six figure inheritance in MLPs exclusively. My portfolio yields 10.6% on the original investment and that yield will probably increase 10%/yr at a minimum. So next year it will be 11.7% then 12.9% etc. This effect of increasing dividends and reinvesting all of them, leads to the portfolio DOUBLING about every four years (not counting inflation, taxes, meltdowns, of course.)
After 9 mo. of research into the market, economics, the meltdown, etc., I am confident that as the tortoise in the race, I will beat the hare in the end with a steady, disciplined approach, that will leave the day traders, short term and medium term investors, in the dust.
Here is the best advice you will ever get from anyone on investing:
1) Think LONG TERM. How many more years will you be alive? I'm 63 and I could be alive another 25 or 30 years. Just about EVERYONE should think long term.
2) Think DIVIDENDS. Academic studies have shown div stock investing has always beat non div stock investing.
3) REINVEST as much of the div stream as possible (ALL if you can) right back into your portfolio.
4) Think MLPs. The superb tax advantages, the high dividends, the solid businesses, are irresistible and REAL.
These four points will make you rich if you do your DD and they will put a big smile on your face. Your future will be assured.
To get started, go here to see a color, graphical, real time (with Sliders - no need to enter numbers!) compound interest calculator, which will allow you to play with various scenarios like distribution rates, inflation, taxes etc.
personal.fidelity.com/...
Good luck!