High yields, low taxes, growth potential--what’s not to like? Fortune has reported that investments in publicly traded master limited partnerships (MLPs) rose from $40 billion to $400 billion in the last 10 years.
Nevertheless, getting both the high cash flow and the modest tax bite is not simple. Advisor Craig Carnick of Carnick & Kubik in Colorado Springs uses the word “nightmare” to describe the possible results of holding MLPs.
MLPs typically are in energy-related industries, such as pipeline operation. They avoid the corporate income tax by passing revenues through to investors, so payouts are often in the appealing 5% range. Deductions, including noncash items such as depreciation, also pass through which means that taxable income may be a fraction of cash flow.
For example, suppose Jane Jones invests $10,000 in a pipeline MLP that pays her $500 (5%) in distributions this year. Only $100 is reported as taxable income, after deductions, in this hypothetical example. Assuming an effective tax rate of 40%, counting all federal and state provisions, Jane would pay $40 in tax and net $460 for the year, for a 4.6% cash return on her investment, after tax.
It’s true that Jane’s basis in her MLP shares will drop by the untaxed $400, raising her taxable gain on a future sale. But such a sale could be in the future, when Jane has a lower effective tax rate, or after her death, when her heirs could have a stepped-up basis.
For all those pros, though, there are cons. MLP income is reported to investors on Form K-1, rather than the usual Form 1099 for investments. What’s more, many states now tax nonresidents who own interests in MLPs that operate in-state, and pipelines can pass through several states.
“Imagine owning 10 MLPs operating in an average of five states,” Carnick says. “That’s 50 K-1s. This can be a non-starter for many investors who do not want to deal with the headache during tax season. Investment advisors often will avoid using MLPs because of this issue, and because the taxation of MLPs can be difficult to explain.”
Instead of investing in multiple MLPs—and getting multiple K-1s—clients can invest in a fund that holds MLPs. “For an investor to be able to realize the tax benefits of MLPs through an ETF or a mutual fund,” Carnick says, “the tax code says the fund can invest no more than 25% of its assets in MLPs. One fund strategy is to invest 25% in MLPs and 75% in other related products, such as MLP structured products, C-Corps that own MLPs, and exchange-traded notes that track an MLP benchmark.”
Carnick finds this type of varied MLP-based fund to be the most tax-efficient strategy. “For our clients, we tailor exposure to MLPs based on their individual situation,” he says. “Overall, we have about 7% of our income portfolios allocated to Eagle MLP Strategy Fund Class I Shares. This fund has very advantageous tax aspects because it provides 1099 tax reporting versus K-1s.”