Answers to Recent Questions: Taxes, K-1s, MLPs, and Why These 7 Pipeline Companies

Authors Note: There is such a -- great! -- flood of information on SA I’ve found if I respond to comments and questions after 24 or at most 48 hours, people don’t go back and read responses and answers there. Better to address questions asked more than once in a new posting for all who are interested:

The subject of buying MLPs arouses strong emotions and elicits all sorts of anecdotal information that is then (often incorrectly) extrapolated from the specific to the general. I’d like to clear up some misconceptions about MLPs, taxes, and K1s, having discussed the issue with two CPA colleagues, and answer the question a number of readers asked as to why I selected the 7 MLPs I selected from among such a large universe.

First, let’s dive in to the topic of taxes and K-1s. Here are some of the issues raised by previous commenters...

...K-1's are sent to the investor and IRS by a company in New York...

Prior to a few years ago, there were a couple dozen companies that provided K-1 service to MLPs. Then PricewaterhouseCoopers’ started buying up the competition and consolidating operations in Dallas. This is a very intensive numbers-crunching process, what with having to deal with the percentage of revenue garnered from each state and assigning it incrementally to each limited partner, etc., so only a big company with super-computing capability found it profitable. Then equally big competitor Deloitte entered the business – nature abhors a monopoly -- and joined a few other competitors with a handful of clients, as well.

...if you sell the MLP, it is YOUR responsibility to notify that company of the sale...if you don't, they will continue to report to the IRS that you are receiving income forever and ever...

Part of this information is half right, part is right but only half the time, and the rest hasn’t been accurate for years. If your MLP shares (properly, “units”) are held at a brokerage firm as most of us do these days, the brokerage notifies the MLP of changes in ownership by 31 January every year, giving them time to decide who to send K-1s to. The MLP does make the changes to its rolls, and does forward the information to their K-1-generating company.

If, however, you hold the shares yourself and transfer them to someone else off-board, or the shares are transferred at your death without notifying anyone, or if you or the MLP makes a mistake, it “could” result in an erroneous K-1. That’s why, featured prominently on every K-1, there is an exhortation to read it carefully and verify the information is correct. As long as you do that (“Hey, this K-1 is for someone else,” or “Hey, I sold this stuff last year”) you’ll be fine. If you ignore this legal document, as with all legal documents, you do so at your own inconvenience.

Another reader speaks truth:

“An important issue the article does not discuss is the ‘incentive distribution’ that the partnership pays to the general partner. [This could be as much as] 50% more of the cash flow than the limiteds.”

All true. Overrides by the general partner to run the business, negotiate contracts, hedge positions, keep up with the K-1s, etc., can run anywhere from a few percent to 50%. But, for me, this is no different than any stock. If we buy shares of Goldman Sachs (GS) or Microsoft (MSFT) or Citigroup (C), we understand they are not running their business as a public service. The point, for me, anyway, is not how much does the general partner get, but how much do my clients and I get? If it’s substantial, dependable, and steadily increasing, I’m happy to pay for performance.

Another stated:

My personal advice for dealing with K1 information or any tax question is number one you should always spend the time, effort, and money to find yourself a competent tax professional.

Absolutely true. Although – nowadays, the K-1s are typically available online so your CPA can garner the information directly, without waiting for you to come in with the proverbial shoebox. And for those of us who use TurboTax, it’s just as easy. TurboTax interfaces with and, at your behest, downloads K-1 information directly to the proper place. Personally, I learn more when I prepare my own taxes but then take them to my CPA for review by more knowledgeable, trained, and experienced eyes.

Another commenter reminded:

Don't forget state taxes if you get a K-1. You may owe state income taxes in states where the partnership does business and you may be required to file a state 1040-NR on your non-resident income.

Absolutely. Much revenue for most MLPs comes from Texas (with no state taxes), Oklahoma, Louisiana, Kansas, and Wyoming (with no state taxes) because that's where the gas has traditionally been found. However, Magellan Midstream (MMP), for one example, generates 0.01% of their revenues from Wisconsin. Unless you hold beaucoups stock in MMP as a Wisconsin resident, you are unlikely to pass the threshold of having to declare that income but, again, this is all spelled out completely on every K-1 and your CPA or tax preparation software is set up to deal with it. (I predict this will become a bigger part of your decision-making as, say, the Marcellus Shale in the Northeast comes on line and residents of high-tax states like New York, New Jersey and Pennsylvania start seeing more income reported from their states…)

I made an error of inductive logic myself when discussing MLPs in Roth accounts. In my experience, spanning nearly 40 years and 20 or 25 MLPs, I’ve never had a client hit the upper limit of $1000 of Unrelated Business Taxable Income (UBTI). But we all need to know that it “could” happen. Having discussed it this week with 2 CPAs and 3 MLPs, I can report that all that will happen is your CPA or tax prep software will advise that you need to pay taxes on the amount received if you exceed $1000 in UBTI in any given year. The reader who said they had read that if you made over a $1000 a year in UBTI, “you could lose the Roth IRA status and have to pay taxes on your whole account!” was misinformed by someone masquerading as knowledgeable. Your Roth is secure. You just have to pay taxes on the incremental amount of UBTI income.

Finally, a number of readers asked why I selected the MLPs I selected, as opposed to the many others available for purchase, as well as provided ideas of their own. If you are interested in expanding your possibilities, I suggest you scan the excellent comments to that article, here.

As I said earlier, I’m looking for three primary qualities when I choose an MLP investment:

1. Is the payout substantial? Does it provide an income stream better than I can find elsewhere?
2. Is it dependable? If the company doesn’t have enough cash flow to regularly pay my share of the profits, what does it matter that in one year or two it was substantial? Are they building new pipelines to serve more people in growing areas? Are they smart enough to hedge a portion of their production to assure a steady enough stream for distributions to me and capital improvements to their infrastructure?
3. Is it steadily increasing. This is my final test. There are a number of SA authors who advocate investing in a growing dividend stream. They – and I -- will buy stocks that may only yield 3% today but which have a history of increasing that by 10% a year. For long-term value buyers, this means we are buying an ever-increasing stream of future earnings. It’s the same with MLPs except that we are looking to buy an already high and steadily increasing dividend flow. As an example, here is OneOK’s (OKS) distribution history (click to enlarge). They started, 12 years ago, paying 55 cents per share (unit) every 3 months. Today they pay $1.08 every 3 months. (Please note that the 2009 figure is for just the first 3 quarters.)

The bottom line is that the 7 MLPs I selected are those I believe offer the best combination of being substantial firms with substantial payouts, well-managed with dependable cash flow and distributions, and steadily increasing payouts based upon running their businesses intelligently and well. (Technically there are only 6, since one, Magellan Holdings (MGG) is the General Partner being subsumed by its subsidiary, Magellan Midstream (MMP)…)

There may be others, and I am indebted to the many readers who pointed out there are also closed-end funds as well as pipeline firms organized as corporate entities rather than as MLPs that may be more appropriate for some tax-advantaged accounts.

For me, using my three primary criteria, I’m going with Boardwalk (BWP), OneOK (OKS), Magellan Holdings (MGG), Magellan Midstream (MMP), Williams Partners (WPZ), Williams Companies (WMB), and Penn Virginia (PVR), the latter for both coal and natural gas.

Full Disclosure: We are long BWP, OKS, MGG, MMP, WPZ, WMB and PVR.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Also, past performance is no guarantee of future results, rather an obvious statement if you review the records of many alleged gurus, but important nonetheless – especially so you are not over-impressed by the fact that our Investors Edge ® Growth and Value Portfolio has beaten the S&P 500 for 10 years running. What if this is the year we under-perform it?

It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Comments

[genetuck]

UBTI is often a negative figure. One reason is that depreciation offsets UBTI. However, the longer you hold the MLP the more you "use up" your eligibility for depreciation, and I was shocked to see UBTI of $750 for just 600 shares of OKS in an IRA. This was because it was bought 13-years ago. I had been accustomed to negative UBTI or very small positive figures. The lesson to me was that you may need to swap out your MLPs in IRAs every ten years or so, or get out of individual issues for a while when UBTI starts building up in them. You can get back in to start again with full eligibility for depreciation benefits. The risk of MLPs in an IRA is that you might be libel to having to pay 35% taxes on UBTI in excess of $1,000, and the broker may charge a hefty fee for filing the report and deducting the tax. But exceeding the limit very rarely happens. Another point is that negative UBTI from one MLP offsets positive UBTI from another MLP in the same IRA.

2009 Sep 20 10:51 PM

[bradiop]

Very informative. Thanks for the info and congrats on reading the follow-up comments and then responding in this manner.

brad

2009 Sep 21 08:29 AM

[macsmart]

Thanks very much for a succintly written, very informative article on MLP's that also clears up much of the misinformation out there.

2009 Sep 21 10:05 AM

[scottzzz]

Excellent original article and response. As a CPA, even I was a bit concerned about the UBTI. And who wants to file 10 non-resident state tax returns each year? The author's reponse of holding a LP/MLP in a Roth is right on, for us "little fish". How can you beat complete advoidance of 8-10% investment income, and having that income is based on non-depleting assets? NG pipelines will be in great demand in 5-10 years as we ramp up NG usage.

Good articles, thanxs.

2009 Sep 21 10:07 AM

[scottzzz]

Of course I meant "complete TAX avoidance on 8-10% investment income". I used to be able to write AND spell.

2009 Sep 21 10:45 AM

[thinking ahead]

Fine article. I do wonder if some of your MLP picks still meet your "substantial" criterion.

2009 Sep 21 11:32 AM

[ArtfulDodger]

JLS, this was a good and badly needed article. Thank you for taking the time to write it!

2009 Sep 21 11:41 AM

[dkdas]

Fantastic article. Very educative also.

DK Das

2009 Sep 21 02:15 PM

[Chancer]

If you own a pipeline MLP like KMR, you receive quarterly distributions in stock.

Your average cost (tax basis) declines every quarter with additional shares.

There is no K-1 to hassle with.

If you need cash, you can sell shares. Taxes will be capital gains (which can be offset with tax losses).

I only wish their were more MLPs that paid in stock like KMR.

2009 Sep 21 03:34 PM

[Smackdown]

One thing about 100% FERC regulated pipelines, like BWP or EPB, and Roth IRAs. These two MLPs are inelegible for ROTH investing. The companies are required to prove to the FERC that they pay tax. IRA investments are OK as tax is due at some point. However, in a ROTH, all tax is avoided. You cannot buy BWP or EPB in a ROTH. There is actually a letter in with the K1 explaining this.

On another note, I do like BWP as well.

2009 Sep 22 11:41 PM

[Smackdown]

EEQ.


On Sep 21 03:34 PM Chancer wrote:

> If you own a pipeline MLP like KMR, you receive quarterly distributions
> in stock.
>
> Your average cost (tax basis) declines every quarter with additional
> shares.
>
> There is no K-1 to hassle with.
>
> If you need cash, you can sell shares. Taxes will be capital gains
> (which can be offset with tax losses).
>
> I only wish their were more MLPs that paid in stock like KMR.
>
>
>
>
>

2009 Sep 23 12:50 AM

[User 69452]

What about in a Non-roth IRA.? The tax deductable kind. Can you have MLP's in these?


On Sep 21 10:07 AM scottzzz wrote:

> Excellent original article and response. As a CPA, even I was a
> bit concerned about the UBTI. And who wants to file 10 non-resident
> state tax returns each year? The author's reponse of holding a LP/MLP
> in a Roth is right on, for us "little fish". How can you beat complete
> advoidance of 8-10% investment income, and having that income is
> based on non-depleting assets? NG pipelines will be in great demand
> in 5-10 years as we ramp up NG usage.
>
> Good articles, thanxs.

2009 Oct 20 05:02 PM