Thinking Straight About Master Limited Partnerships

| About: Enterprise Products (EPD)


Enhancing objective decision making.

MLPs as Sector and Income Plays.

Tax Factors to Consider.

Master Limited Partnership- MLPs- are complex financial instruments. They have a complex tax structure with nuance that can have unforeseen consequences. They have complex financials that make it difficult to use conventional analysis tools. They issue units, not stock. They provide distributions, not dividends. They operate in industries few people really understand, and they report operating results on K-1's. It is little wonder that they confound most people, even those that have invested in them (especially those that have invested in them).

I've written 15 MLP articles on Seeking Alpha, mostly about the tax nuances. The last one was about 3 years ago. That's a lot of articles about one subject, but they were necessary to cover all the fine points.

Over the years, around Tax Season, readers routinely dig out my old articles and e-mail me with questions. This year there has been a much greater influx of "clicks" and e-mails.

It seems that more and more investors are trying to evaluate their holdings and are getting "muddled up" in their thinking. This is understandable because some MLPs have lost 90% in value, some are creating unexpected tax issues because of reorganization or forgiveness of debt, many have cut distributions and there has been more than normal discussion surrounding them. So, with this renewed interest, I'm dragging out the keyboard and hoping to provide some insight.

Based upon the inquiries I've received, many investors have recently taken a beating and are really baffled about what they should be doing. Is the air out of the balloon? Was the balloon ever really filled? Are MLPs good, bad?

This is not unusual, for anytime an investment takes a hit. Emotions tend to come into play.

No article can resolve issues that are as varied and personal to each MLP owner. Notwithstanding, I'll try to address some factors one needs to navigate in reaching their own, personal decision.

With all that said, where does one start?

First, contrary to how they are marketed, MLPs are NOT a sector.

They are a TAX STRUCTURE. It just so happens that the particular TAX STRUCTURE presents the most benefits in certain types of business operations and industries: those with depletion allowances and relatively high depreciation. That is why they are primarily Energy and resource plays.

So, the starting point in evaluating one's MLP is not the MLP, but, rather the particular sector they inhabit. For instance, one of my favorite MLPs is Enterprise Partners (NYSE:EPD). But it is not "in the MLP sector", it is in the ENERGY sector- more specifically, mid-stream energy.

So, one must start by asking how much energy, if any, they want in their portfolio. If so, what is the best play. Here are just a few:

1) Directly in oil through an ETF (NYSEARCA:OIL)? or,

2) Integrated companies like Exxon (NYSE:XOM)? or,

3) Alternate energy?

Simply stated, What Makes The Most Sense?

Of course, MLPs inhabit many sub-sectors- for example, mid-steam, up-stream, E&P and resources. For simplicity, I'll just tackle one sub-sector, mid-stream, because I believe it is most representative.

Maybe one should ask if they are invested in mid-stream because ... well ... because they invested in mid-stream and not because they concluded mid-stream?

Of course there will be differing answers, but I'll share with you my thinking.

The energy sector is down, mostly because oil is down. It is normal for commodity based companies to "price-react" less violently than the underlying commodity. So, XOM, EPD, etc., have fallen less dramatically than PPB oil. On a rebound in PPB oil, it's likely that OIL will pop more than the companies.

So, on the way down, risk/reward favored XOM and EPD, but on a recovery risk/reward may favor OIL.

In essence, the protection in a downward PPB oil market has been realized. In an up PPB oil market it won't provide the "kick" a direct investment in oil might. So, if one is waiting for oil to rebound for their MLP to get price appreciation, they may be looking at the wrong piece of the puzzle.

Now, i won't pretend that direct investment in PPB oil isn't volatile (though potentially more rewarding) and it certainly is not for everyone. Maybe it's best for many to sidestep this potential and go with mid-stream? Well, mid-stream does have one nice feature- it tends to provide a steady income that can be appealing.

In order to evaluate the "income stream" we need, first, to discuss tax considerations. I have done my best in previous articles to try and unmask the marketing that promotes MLPs as tax shelters providing tax free or tax favored income.

MLPs, like IRAs, are tax deferral devices. Contrast this to a ROTH, which is a true Tax Shelter.

With any tax deferral device the tax benefit is afforded by the time value of money (the ability to put tax savings to earn more returns) plus any differential in tax rates.

In order to quantify the tax benefit on deferral devices, one must consider the taxes paid in the future. This requires making various assumptions about one's tax brackets, investment returns, holding periods etc.. Then one can compare it to alternate investment choices to determine a comparative benefit/detriment of one over the other

There are several unusual considerations regarding MLPs. As I detailed in several articles MLPs can actually diminish tax benefits that are otherwise naturally afforded both IRAs and ROTHS as a result of Unrelated Business Income Tax (UBIT) and "recapture".

I feel the necessity to add that when I first talked about "recapture tax" in a Seeking Alpha article, there was a complete uproar. Investors said that such an outcome couldn't possibly be accurate. The subject went "viral" and there were comments on just about every investing site that existed. Broker-dealers told their clients to disregard my theories. The consensus was that it could not be so.

Thankfully, over time, as I added more and more authority and closed out with yet another article, opinion started to slowly change. Within one year the "conventional wisdom" reversed and "recapture" is now routinely accepted. The MLPs and broker-dealers have actually modified their reporting to accommodate the fact that this hidden tax has now been exposed and that failure to recognize it might create a liability for them

So, as counter-intuitive as an IRA or ROTH having to pay tax seems, it is a reality. Furthermore, the longer the MLP remains in the IRA, the greater the deferred tax liability.

So, if one includes their MLP in their IRA, they must reduce their net income by any taxes the IRA or ROTH will have to pay. Though some promoters still suggest that MLPs and IRAs aren't so bad, they are mistaken. There is no place for a MLP in an IRA.

That is because if one is really dead set on owning a MLP in an ROTH or IRA, there are alternate ways of accomplishing this without the "baggage" such as selling Deep in the money (DITM) naked puts, or buying calls- or both (creating a synthetic long). I wrote an article, years ago, on how to how to replicate an MLP without owning the MLP's baggage.

When it comes to owning MLPs in taxable accounts one must also reduce the income stream to account for future taxes on sale of the MLP. But there is a "hitch" in approaching such a calculation because MLPs defer what could otherwise be favorable Long Term Capital Gains (LTCG) on dividends and, instead, incur the higher ORDINARY income tax rates on the "recapture" at time of sale. This can tip the scales enough to reveal that there is adverse overall tax benefits not "tax free" benefits.

It's possible that a MLP may defer what could have been a 15% LTCG in traditional stocks for a 30% or higher ordinary income tax. Larger positions in MLPs may even run the risk of actually pushing one into a higher tax bracket.

When the possibility exists that future tax rates will exceed the present tax rate, a net benefit is still possible. But the only way this can be achieved is if adequate time is given to the time value variable, and as a result MLPs must be held long enough for the time value to overcome the tax rate differential.

This can be illustrated, generally, by asking if one would look to avoid paying a 15% tax today and, instead, pay a 30% tax tomorrow. Not likely. However, as we increase the holding period the decision is less clear and at very long holding periods, surely it favors the deferral. The question is: How long does the holding period have to be before a higher future tax rate is overcome?

Now, there are many factors, besides just tax rate differentials, that have to be factored in to ascertain if the MLP tax structure is a plus or minus, and these factors include different types of taxes, returns, time frames, tax brackets and potential changes to these factors and the tax code. In two previous articles I went into such a calculation and here.

Notwithstanding the imprecise nature of any conclusion based upon assumption, let me summarize the highest probability:

1) MLPs receive NET favorable taxation only if held at least 15 years, and maybe, 20 years.

2) MLPs receive NET un-favorable taxation if held less than 10 years and maybe as long as 15-20 years.

3) The longer one keeps the MLP, even though the tax benefit swings in their favor, it is past history. The tax free income has been spent and what remains is an enormous tax burden.

4) A tax avoidance "lock-in" can occur. If someone invests, let's say $50,000, in an MLP and over 20 years received 5% yearly distributions and wanted, TODAY, to sell for $50,000 ... it is ALL ordinary income even though they are just getting back their initial investment. Worse yet, if they have a "principal loss" and sell for only $40,000, it is still ALL ordinary income.

This tax lock-in is evidenced in many of the queries I receive: "I'm reluctant to sell because if I sell, I just have to pay income tax".

The problem with this logic is it ignores that the tax burden will just keep getting bigger. The bigger the burden the less likely to sell. So what's the sense of owning something that presents obstacles to realizing its value?

I look at this similarly to when my 15 year old classic car breaks down. I solace myself by remembering when it was new and how much I enjoyed it, but today, it's just a pain in the butt and its not getting any newer.

My previous articles also receive a lot of comments along the lines of, "I'll keep it until I die and my children will get a step-up". This can work, but here's how I think about that:

1) Does one really want an investment that one has to keep for 20 years for it to make tax sense? or they might have to never touch it, leaving it to one's heirs?

2) What is so special about this particular investment that one would be willing to answer YES to the first question?

3) Though it may pay high income, is it really that much more if one is tax-locked and can't touch the principle without consequence?

Let's examine the "income stream" for flaws. On the top of the list is the actual return. I hate to remind everyone, but return is reflective of risk. Too many jumped on high return LINN (LINE) (as I did) when compared to, say EPD. Now LINE is almost worthless. This is not unique, but more the rule.

Furthermore, the income stream is subsidized by returning principle and not by earnings. Now many MLPs are on safe ground but sustainability must be considered. By no means is this income stream immune from adversity.

Lastly, the income stream, as with any income stock, reacts negatively to higher interest rates. So when rates rise, it will adversely effect the MLPs price.

Generally speaking, income oriented securities, will experience their best price appreciation as rates fall. When rates start back up, the price appreciation suffers. Unfortunately, the full appreciation in price one would normally expect hasn't fully materialized because of falling oil.

However, as oil recovers, and if rates start to rise, future appreciation in price may not replicate what was experienced in the past. In short, the best may be in the past.

So, when one evaluates their MLP, they need to take into account whether or not the apparent high income stream may well be the Siren's Song.

Summary: Now, I can't recommend to anyone what they should do with their MLP. There are too many factors. But I can share with you my personal thinking when I was faced with the situation.

If the preceding points seem to indicate I'm on the SELL side, you're right. I've owned and sold MLPs and I sold BECAUSE I analyzed the factors as objectively as I could.

Back in January of 2013 I had quite a substantial holding in EPD and a lesser holding in LINN Energy . I sold them off. I had EPD for many years and "bit-the-bullet" paying considerable tax. Less so with LINE.

When I sold, I wrote an article detailing exactly WHY I sold them. I really, really suggest readers consider reviewing it as my selling wasn't on expectation of drops between 50% and 90% in a few years .. no, not at all. I wasn't trying to time the market, nor did I have any expectation that what would follow in depreciating prices was so near and so severe.

I sold my positions because .....

Conclusion: Successful investing is hard work and takes effort and time. I was tired of constantly thinking "what should I do?" all the while knowing I was just accumulating ever greater tax liabilities as each quarter passed. The MLPs were like a Sword of Damocles.

Did I really want to send ahead a tax burden to worry even more about in retirement? Did I really want to just be "locked in" to an investment? It was just going to get worse- never better.

In the end, don't investments carry enough worry and concern? Do I really have to add some that is avoidable? Is that how I want to spend my retirement?

Finally, there are so many opportunities for investment that don't have the negative overhangs associated with MLPs. This includes non-MLP companies within the Energy Sector, other income investments (REITs, utilities, dividend achievers) and alternate ways of owning MLPs (ETNs, option strategies, hybrids). I find nothing so unique or special about MLPs to subject myself to the complexities. There are simpler ways to invest.

So, in the end it may be, as is said, pay me now (a little) or pay me later (a lot).

Final chapter: If you read the last article linked, you will see my concluding thought was that if EPD ever dropped because of market conditions, I'd reconsider it, but not through the MLP- rather by selling PUTS in my ROTH. Now that's a TAX SHELTER.

Maybe, now is the time. So, while you're thinking, I'm thinking.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.