Master Limited Partnerships: Stop The Insanity

Includes: EPD, LINEQ
by: Reel Ken

"The reason I talk to myself is because I'm the only one whose answers I accept."
George Carlin

There are many articles on MLPs and I must lay claim to having authored my fair share. These articles attract wide and diverse views about investing in the MLP space and I thought I'd attempt the monumental task of putting the main issues in one place, for all to see, ponder and offer comment. So, here goes ...

First, I need to set the record straight -- MLPs are not an investing sector they are a TAX STRUCTURE. The first thing everyone needs to decide is NOT if they should invest in an MLP, but, rather, should they invest in the underlying sector and then the particular company or companies representing that sector. Since the vast majority of MLPs are in the midstream energy sector, let's take a look at that sector.

Midstream energy is mainly the transportation of oil and gas through pipelines. Though many of these companies have some upstream and downstream attachments most of their revenues come from charging fees for the use of their pipelines.

Though share prices in this sector tend to go up and down with oil/gas prices and the energy sector in general, they should be mostly independent from this. As such, they offer a more conservative play and steady income streams. They can be considered one of the safest and most reliable plays in the energy sector. Sort of the tortoise of the sector (though they have been running pretty fast lately)

Second, assuming you want to invest in this sector, does the MLP structure afford meaningful tax benefits? Many of the companies in the downstream energy sector, such as Kinder Morgan (KMP), (NYSE:KMI), (NYSE:KMR) and Enbridge Partners (EEP), (NYSE:EEQ), (ENB)offer traditional corporate and MLP structures. More and more are offering this duality as time goes on. So, there is some choice on whether to go the traditional corporate route or the MLP route.

There is a lot of debate on which structure works best for the investor, so let's simplify the arguments. Distributions from an MLP are not dividends, but rather mostly return of capital and some net earnings. As such, most of the distributions are not currently taxed. However, when units are sold, there are some complicated tax rules that have the effect of retroactively taxing your previously untaxed distributions at ORDINARY INCOME RATES.

On the surface, this looks like a pretty good deal -- a deferral of taxes. Not so quick. If you invested in a regular corporate entity, you would be afforded capital gains treatment on the dividends and any price appreciation. As a result, the MLP potential tax liability at ordinary rates, diminishes the effect of the deferral by increasing the tax rate on sale. It becomes an analysis of dividends taxed at lower rates versus sales proceeds, deferred to a higher tax rate. Here's an article that draws that comparison and its worth looking at the methodology employed.

Third, what about owning MLPs in an IRA? Too many people confuse the advantages of investing in the sector with investing in MLPs as a structure. The sector (midstream energy) is ideally suited for retirement accounts and retirees. The steady, conservative income stream is what most retirees want. In fact, their current yields have attracted so many investors it has resulted in outsized share appreciation for most companies in this sector. They have the same attraction now, that utilities had in the 1950s and 1960s.

The MLP structure adds nothing to the IRA investor. Actually, through a series of very complex tax rules, MLPs detract from the usefulness of midstream energy in IRAs. One would be better off investing in corporate members of the sector rather than MLP members. So, instead of thinking about investing in MLPs, think about investing in the sector and pick the best company you can and then, only then, choose the appropriate structure.

For instance, I like Enterprise Partners (NYSE:EPD) and this is only available in MLP form. So, if I wanted to own EPD in an IRA, I would have no choice but to go with the MLP. On the other hand, if one were to pick LINN Energy (LINE) as their favored company to invest in, they could choose the Corporate version (LInnCO) instead of the MLP version.

So, for IRA investors that have decided on exposure to midstream energy, pick the company that you like best, and go with the corporate form, if available. Otherwise, go with the MLP version. If you picked the right company, the tax issues will be minimized.

Summary: Let's try and uncomplicate the MLP space by first talking about the midstream energy sector. Then let's just look at the best companies to meet the investor's objectives in that sector. If the company chosen happens to be an MLP, then make any positive/negative adjustments depending upon your view of the tax environment. If the tax structure works for you, great, if against you, then maybe you should look into other structures within the sector.

Disclosure: I am long EPD, LINE. 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.