Master Limited Partnerships: The Phantom Menace

by: Reel Ken


The Tax Menace In MLPs.

The Phantom Income Stream of MLPs.

Growth Stocks for Income.

It's Total Return That Matters.

I recently wrote an article on my views of Master Limited Partnerships -- MLPs. It represented my 16th article about MLPs and the first in several years. The article tried to touch briefly on past topics and present my conclusion.

Anyone reading the article would realize that I had concluded that the benefits of MLPs are mostly illusory and, in fact, may be harmful. My conclusion was based upon the taxation component of MLPs if held in an IRA or ROTH and the deferred tax liability if held in a taxable account.

But most importantly, these tax issues could cause an investor to be "locked-in" to the investment. This "lock-in" might encourage the investor to hold, when they should sell and/or restrict them from seeking better opportunities in the future. Of course, any "lock-in" would also raise the likelihood to rationalize their predicament or cloud their analysis.

When I first wrote about these complexities several years ago, there were many rationales for those holding MLPs. Among the most frequent was the thought that they would simply hold the MLP indefinitely, ultimately passing it on to their heirs and avoid the tax via the death cost-basis step-up. Meanwhile they would be rewarded with tax favored high current income.

Inasmuch as this thinking surfaced again in my most recent article, I thought it worthwhile to provide a more detailed analysis.

Before I start, let me say that any analysis must be based upon assumptions. These assumptions must include factors such as holding period, investment returns, tax brackets and tax laws. To the extent that these assumptions, IN THE AGGREGATE, are faulty, then the conclusion will be faulty.

For instance, if favorable Long Term Capital Gains is eliminated the entire discussion is null as the MLP is the clear winner. On the other hand, if MLP taxation is altered or the MLP reorganizes or converts to a "C" Corp, then entire MLP rationale disappears.

Whatever assumptions are used, there will be some give and take in both directions. If one doesn't assume so, then one must throw out the possibility of any analytical approach to the issue.

With that said, here are the assumptions I'm going to deal with:

1) The Total Return of MLP and a competing stock ("XYZ" )are identical

2) The MLP has a distribution of 5% which is 80% return of capital (no tax) and 20% ordinary income (30% tax)

3) XYZ is a growth stock, pays no dividend and is eligible for Long Term Capital Gains (LTCG) at a 15% tax rate

4) Risk/reward metrics (such as Alpha, Beta, Sharpe ratio and standard deviations, etc.) are identical for both the MLP and XYZ at all times

5) Any increase/decrease in the distribution rate or capital appreciation for MLP will have a corresponding increase/decrease in XYZ, so the total return remains constant.

Making these assumptions, we can now equalize and analyze identical income streams.

What, you say, identical income streams? There is NO income stream for a growth stock.

O.K., there is no automatic income stream, but one can simply make withdrawals from XYZ in such amounts and such times as a distribution would be made from the MLP.

So, let's look at the first year. Let's say one invests $50,000 and we start by looking at the MLP.

1) The MLP makes a distribution of $2,500.

2) Of this, 80% ($2,000) is not currently taxable as return of capital.

3) The remaining $500 is taxed as ordinary income, at 30% and a $150 tax is paid. Not bad ... $150 tax on $2,500 ... loving my MLP.

Now, we move on to XYZ. XYZ has grown by 5% and is now worth $52,500. One simply withdraws the equivalent distribution amount of $2,500. Here's the breakdown:

1) $2,500 withdrawn. "Income stream" equalized

2) The withdrawal, for tax purposes is proportional and is approximately $2,380 cost basis and $120 capital appreciation.

3) The tax on the capital appreciation is LTCG at 15% and equals $18.

So, for the first year, the tax on MLP is actually many more times greater than XYZ. The MLP distribution would have to actually be nearer to 98% return of capital to match the tax on XYZ. This is far above MLP averages, which are 80%.

But, the XYZ picture is not fully representative as the character of the withdrawals changes over time. Assuming everything stays the same, the proportion of XYZ's withdrawal attributed to cost basis shrinks and a greater proportion of the distribution is LTCG.

Here's a chart the details the effect:

Year Value Withdraw Basis LTCG Cost Basis
1 50 000 2,500 2,381 119 50,000
2 50,000 2,500 2,268 232 47,619
3 50,000 2,500 2,160 340 45,351
4 50,000 2,500 2,057 443 43,192
5 50,000 2,500 1,959 541 41,135
6 50,000 2,500 1,866 634 39,176
7 50,000 2,500 1,777 723 37,311
8 50,000 2,500 1,692 808 35,534
9 50,000 2,500 1,612 888 33,842
10 50,000 2,500 1,535 965 32,230
11 50,000 2,500 1,462 1,038 30,696
12 50,000 2,500 1,392 1,108 29,234
13 50,000 2,500 1,326 1,174 27,842
14 50,000 2,500 1,263 1,237 26,516
15 50,000 2,500 1,203 1,297 25,253
16 50,000 2,500 1,145 1,355 24,051
17 50,000 2,500 1,091 1,409 22,906
18 50,000 2,500 1,039 1,461 21,815
19 50,000 2,500 989 1,511 20,776
30,213 17,287

One can see that over time a larger percentage of the withdrawal represents LTCG. For instance, around years 14-15, the $2,500 distribution would be considered about 50/50 cost basis and LTCG.

If we look at the entire 19 year period, about 34% of the distributions are subject to LTCG and the rest is return of cost-basis.

The entire LTCG tax over the 19 years would only be $2,593.

How does this compare to MLP? Well, MLP incurs $150 in tax each year and over 19 years that totals $2,850.

So, the LTCG on the systematic withdrawals of XYZ will represent less tax than MLPs 80% tax free withdrawals. That means that the NET INCOME on XYZ exceeds that on MLP.

Furthermore, the net after tax income on XYZ is MORE FAVORABLE for the first 11 years. So, based upon time-value of money, the advantage is quite substantial in favor of XYZ.

Now, I ended this illustration at 19 years for a simple reason. Once the MLP distributions equal the initial cost and basis is reduced to ZERO, future distributions of capital are no longer tax free but are LTCG.

Starting in year 20, the entire math changes and ONLY XYZ receives any deferral of tax. that means the only chance that MLP has to beat XYZ is during the first 19 years ... and this, it does not do. Thereafter, XYZ just piles on additional advantage over MLP.

Now, I readily admit that this illustration is a PURELY HYPOTHETICAL situation. Different assumptions can be made that will tip the scales one way or the other. My purpose was not to prove, beyond all doubt and reason, that the tax favored income stream for a MLP is always and forevermore, PHANTOM.

Quite the contrary, my purpose is to illustrate that there are many ways to reach an outcome. For instance, I could have assumed that the MLPs income stream is without any current tax (100% return of capital). This would make it about $80/year better than XYZ . But then, I could have said it will probably cost one $80/year more in tax help doing the returns than XYZ.

I could have taken the illustration 30 years and not 20 and moved the needle back towards XYZ. I could have done many things. But here's what I didn't do:

1) I didn't account for the investor needing more/less of a distribution than MLP provides automatically. In either case, the taxation issues favor XYZ.

2) I didn't account for the possibility that MLP fail to precisely and in every way address the investment parameters of the investor and that, through time, these parameters never change and the myriad of factors that surround investments of all types never move adversely against the MLP.

3) I didn't use 6% or 7% or 8% or higher distribution rates. The higher the distribution rate, the sooner MLP reaches zero cost basis and the sooner the non-taxable portion of a distribution becomes LTCG and loses all advantage over XYZ.

Now, to be fair, there are many factors that could tip it one way or the other and need to be considered.

First, the percentage of MLP distribution that is taxable. I used industry averages, and a specific MLP could be more or less. Furthermore, this ratio will change over time for any given MLP and I assumed it to be constant. So, there is uncertainty and one can resolve it any way they wish.

Next, this illustration assumes that XYZ and MLP are identical. No two stocks are identical. Heck, no two MLPs are identical.

Quite frankly, I would have rather weighed Total Return, over 20 years, heavily in favor of a growth stock. In fact, it only takes about 20 basis points in increased return for XYZ to overcome 100% tax free returns for MLP.

Summary: There are many investors that are lured into MLPs and overestimate the tax benefits or income stream. In my previous article I detailed the "curse of this menace". In this article, I address those theories that the "curse of the menace" can be avoided by holding till death and receiving a step-up in basis. While that is true, the entire reason for such a posture is to enable tax favored income.

The fact is, there IS NO tax favored income. That if one wants Tax Favored income, the best place to visit is traditional stocks that receive LTCG.

Conclusion: MLPs are TAX Structures, they are not sectors. Investing in an MLP has merit only when viewed in terms of the sector and the Total Return one expects to receive. Total return is made up of income and growth.

Furthermore, the MLP income stream is PHANTOM. The fact that most of the income is not taxed is a result of returning principle which is very easily replicated with traditional stocks. All I did in this example was to return XYZ's principle each year to match, and better, MLP.

So, as is almost always the case, investors must look at overall investment merits of any investment. Forget about the income stream, it is just an illusion. What matters is what always matters .... Total Return relative to risk/reward.

So, instead of falling for the Siren's Song of illusionary income, one must never forget to evaluate any equity ... MLP, stock, bond etc., on its merits of total return relative to risk/reward.

Many investors have difficulty looking at their own holdings objectively. I owned EPD and LINE when I first started writing about the tax nuance associated with MLPs. In fact, I had a pretty substantial interest in EPD that dated back to 2005. So my tax liability on sale was significant.

In the process of writing I was forced to look inward. I took as objective a look as reasonably possible and concluded that the problems were not worth the opportunity and I sold them off, paid the tax and went forward.

As fate would have it, I'm now in a position to invest in EPD, once again, at a much lower value and do it by selling puts in my ROTH. Better pricing, better taxes equals better returns.

Perhaps this article will help others to recognize the Phantom Menace that is MLP.

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.

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