Master Limited Partnerships (MLPs) are interesting investing vehicles. I own several and have found them to be excellent investments. In a previous article I outlined my case for and against owning them.

My experience with that article (and several subsequent articles) indicated that there is a great deal of confusion in the investing world regarding both how MLPs work and the purported tax benefits of owning a MLP. This article will discuss how they work and whether they provide meaningful tax benefits.

Before one can fully appreciate the tax nuances and make a decision on investing in an MLP, it would be helpful to understand the MLP structure.

To do this, let’s create our own hypothetical MLP. This company will build oil and gas pipelines, lease them out to various entities and collect rents. It is organized as a partnership so we can make regular distributions to our investors. As a partnership, the investors will report their proportionate share of any income and pay any taxes. This is a pretty basic and simple MLP design.

We can’t build anything without cash, so we start by raising $1,500,000 from ten investors, each contributing $150,000. Next, the pipeline is built and lastly we lease it out. The lease income (after salaries, fees, expenses, etc.) is $100,000 per year, or $10,000 per investor.

To incentivise our investors we agreed to distribute this $10,000 annually to each of the ten investors. The investors appear to be getting a “dividend” of around 6.7% ($10,000 distribution divided by $150,000 investment).

But, this is hardly the case and we need to look a little deeper. First, we have to account for depreciation of the pipeline. To keep it simple, assume the pipeline is fully depreciated in a straight line over 15 years. That means we can deduct $100,000 per year from our MLP taxable income resulting in zero taxable income.

The investors are happy, as they get a $10,000 distribution and pay no current tax. “100% tax free”, or so it seems.

Looking deeper, we find that the $10,000 yearly distribution is classified as a return of initial investment, gradually reducing the tax basis of the investor. If kept 15 years, the total distributions equal the initial investment and the basis is been reduced to zero.

Let’s look at what happens after 15 years. The pipeline has been fully depreciated. Assuming it is still in service and the lease income continues, each investor will have to declare and pay tax on their distributive share of the $100,000 income. This $10,000 distribution instead of being “100% tax free” is now “100% taxable”. The tax is computed as ordinary income.

Some readers will immediately jump up and say that distributions made after receiving a complete return of the initial investment are capital gains and not ordinary income. Well, this is not quite true. Only distributions that exceed taxable income in any given year would be taxed at capital gains. So, if the MLP earned $8,000 per investor and distributed $10,000, then $2,000 would be subject to the favorable capital gains rate, the balance...ordinary income

Well, you may think you can just liquidate your investment in the 15^{th} year, buy something else and avoid receiving ordinary income. Not so. When if a partner in an MLP sells their shares, any proceeds received from the sale, is treated first as a recapture of their proportionate accumulated depreciation. This is taxed as ordinary income, not capital gains.

That means the $10,000 in yearly distribution that was sheltered from tax, which, after 15 years now totals $150,000, is now taxable as ordinary income (unless, of course you receive less than $150,000, in which case only the amount actually received is taxed). Not only will this be taxed at a high rate but might even force the taxpayer in a higher bracket. Only any amount received in excess of the $150,000 accumulated depreciation recapture receives favorable capital gains tax rates.

Though the MLP can't avoid the depreciation recapture tax to onvestors selling, it can mitigate the impact of the taxes on continuing investors. This is accomplished by continually building more and more pipelines, acquiring other pipeline companies or even drilling for oil or gas. All of these investments create new depreciation that offsets (or masks) current income. So the original design is perpetuated. I call this the “depreciation pyramid”.

To the extent that the partnership successfully builds the “depreciation pyramid”, future distributions could be sheltered from ordinary taxation and, after the investor’s basis reaches zero, would then be afforded capital gains tax rates. However, the “recapture clock” continues to build and even more will be taxed at ordinary rates upon sale.

As long as the Partnership can continue to grow profitably and you don't sell, everything works well. You can continue to get distributions that may increase over time and shelter much from current taxation. But you must always keep in mind the “elephant in the room” if you decide to sell.

That leads to the fundamental tax sheltering analysis. Given all these tax issues can an MLP be properly viewed as a “Tax Shelter”? More directly, does income without tax now, compensate for higher taxes in the future?

In order to address this question let me compare the MLP first to an investment, such as a utility stock, that pays a dividend. For this illustration I’ll assume the utility pays a 6.7% dividend matching the MLP distribution. I must stress that I am not comparing it in terms of its investment merits, just for a tax comparison.

Qualified dividends are currently taxed at reduced capital gains rates. For 2012 the maximum rate is capped at 15%. What the future holds is anyone’s guess, but let’s assume that it remains at 15% and that the maximum ordinary rate remains at 35%.

Now we all know that there is an advantage to paying a tax later than sooner. But most analysis assumes that the future rate will be lower or identical.

This leads to the question, is it better to pay a 15% tax each year or a 35% tax later?

In other words, if the $10,000 distribution was a dividend and taxed at 15%, would it be better to pay $1,500 per year at the dividend tax rate or use an MLP and defer all tax to point of sale, but pay a 35% ordinary income tax rate on the recapture?

This answer depends upon the holding period and the investment return that can be earned on the taxes that are deferred. So let’s look at the return necessary to “break even”.

If the investment was held for 5 years ,then sold, $50,000 in total distributions would have been received. If the investment was a dividend paying stock, taxes would have totaled $7,500 ($1,500 per year). If the investment was an MLP, no taxes would have been paid on the distributions, but $50,000 would be subjected to recapture at 35% tax rate. The tax would be $17,500 or $10,000 more than the utility dividend taxes.. On the plus side it has been deferred 5 years.

So, the analysis is pretty simple. If the taxpayer saves $1,500 in yearly taxes but has to come up with $17,500 in five years, they would need to earn an annual percentage rate (APR) of nearly 29% to "break even". And this would be an after-tax yield. Not looking good for the MLP.

If the holding period was increased to 10 years, the “break even” return would be just under 15%APR and if the holding period was 20 years, just over 7.5%APR. Once again, after tax.

Though the math is more complicated, the result would be the same if the investor bought, say, a growth stock that paid no dividend and systematically sold enough shares each year to generate $10,000 in income. Of course, this assumes that the ROI of the stock and the MLP are identical.

I would conclude that the hurdle of such a difference in tax rates is significant and current tax rates clearly favor a stock over an MLP. This does not account for any investment advantages the MLP might have over the stock, or vice-versa.

This illustration assumes that the MLP would be sold at some point. Of course, if the MLP is held indefinitely, then the tax advantage tilts in favor of the MLP.

If the Bush Tax Cut for dividends is not extended past 2012, dividends would be taxed as ordinary income. The whole picture would now turn around and favor the MLP. A similar result would occur if capital gains rates were increased. It is clearly better to defer taxes if income will be taxed in the future at rates identical or less than current rates.

So, we must conclude that as long as capital gains and ordinary income tax rates remain so disparate, the MLP has no tax advantage over a stock with an equivalent ROI. If these rates start to get closer, the picture starts to change.

What if an investor wanted to own an MLP and avoid all these complexities by choosing to invest in a MLP ETN? Since the ETN dividend is taxed as ordinary income, the direct MLP investment would show a tax deferral advantage. So, the ETN reduces the complexity but, in exchange, gives up tax advantages.

Conclusion: The MLP structure is complex and anyone investing should make a concerted effort to understand the tax issues. A simple representation that an MLP is a tax shelter or provides tax free income does not tell the whole story.

There is a clear tax advantage for MLPs only when compared to other investments that would be taxed at comparable rates (such as bonds, ETNs, and many REITs). They do not provide any tax benefit when compared to investments eligible for capital gains treatment. In fact, they would be at a severe disadvantage.

This analysis considers only the tax treatment of MLPs and other investments. As an investment vehicle it has some qualities that set it aside from many other investments. An investor should no more eliminate them on the basis of the tax issues than buy them solely for the same reason.

That being the case, the prospective investor needs to look at the MLP as a long term, buy and hold investment, or one that they believe can provide superior returns or safety. Investing in an MLP premised that it is a tax shelter, of sorts, may prove to be illusionary.

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I do own EPD, NRP and LINE.