3 High-Yielders That Make MLPs a Snap

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I’m a big fan of master limited partnerships (MLPs) — partnerships that trade publicly on an organized stock exchange. Here at Profitable Investing, we’ve made a small fortune on conservatively managed partnerships that focus on “toll taker” aspects of the energy industry, such as pipelines and natural-gas gathering and processing.

The very first MLP that I recommended to subscribers back in 1991, Buckeye Partners, L.P. (BPL), forms an important piece of our model portfolio today. Since that initial writeup, BPL has racked up a spectacular total return of more than 3,200%.

Yet the outlook for MLPs today is, if anything, more favorable than it was back then. During the past five years, an energy boom has taken hold right here in the U.S. New drilling technologies (such as “fracking”) have boosted domestic production of crude oil by 49%. Natgas production has also soared with the tapping of newly discovered reserves in the nation’s shale deposits (Marcellus, Utica, Eagle Ford, etc.).

MLPs supply much of the infrastructure for transporting oil and gas from these fields. So the partnerships find themselves in a powerful growth spurt that could last another decade or more.

Those Nasty K-1s

From an investment standpoint, MLPs also offer the attraction of generous cash yields up front, partly (or even mostly) tax deferred. Growth, income, plus a tax break — what’s not to like?

Well, just one thing.

At tax time, MLPs send you a complicated Form K-1, along with a mass of instructions — written in pure legalese — for reporting your share of the partnership’s income and deductions. It’s a headache for your tax preparer (read: extra fees on your bill), and an even bigger headache if the preparer happens to be you.

Adding insult to injury, many MLPs don’t release their K-1s until the middle or even the end of March. So you’ve got to hustle to get your taxes filed on time.

Personally, I’m willing to put up with some of that grief to capture the outsized returns available from MLPs. As I get older, though, and maybe a bit less patient with tax gobbledygook, I’m more inclined to look for shortcuts.

I’ve found two types of “paperwork cutters” in the MLP space that work for me. Let’s talk about the pros and cons of each of them.

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Packaged Together in a Fund

MLP funds are the first paperwork cutter. Some are organized as mutual funds, some as ETFs and some as closed-end funds, but in all cases the basic concept is the same: A bunch of individual MLPs get packaged into a single portfolio. The fund does all the tax accounting for you and sends you a simple Form 1099 at tax time. You receive quarterly dividends, a portion of which may qualify as a tax-deferred return of capital. You can tuck MLP funds into your retirement account without any fear of generating so-called unrelated business taxable income.

The downside? Funds charge management fees, which reduce your cash yield. In addition, because MLP funds are organized as corporations, they book a fair amount of deferred federal income tax, which eats into the funds’ net asset value.

In effect, the funds are making a provision for the same tax expense that you as an individual MLP owner are postponing until you sell your partnership units. Thus, the share price of an MLP fund tends to grow more slowly than the prices of the MLPs in the fund’s portfolio.

However, these aren’t necessarily fatal disabilities. The biggest exchange-traded MLP fund, Alerian MLP ETF (AMLP), is yielding 6% based on the past year’s dividends. If you’re an investor primarily focused on a high, growing income, with capital appreciation as a secondary goal, a fund like AMLP can fit the bill.

Ease Your Way with i-Units

If you want to cut your paperwork to the vanishing point, go with a special MLP class that pays quarterly distributions in stock, rather than cash. They’re called i-units, since they were originally developed for institutions that didn’t care to grapple with the tax complexities of MLPs.

Only two of these critters exist, Enbridge Energy Management (EEQ) and Kinder Morgan Management (KMR). I’ve recommended both in the past as energy “middlemen” — both because of the nature of the pipeline business, and because these funds stand between you and a headache at tax time.

The Kinder Morgan and Enbridge Energy families of securities each have two classes of partnership units, one that pays quarterly distributions in cash and another that issues additional shares (i-units) valued at the same amount as the cash distribution (EEQ and KMR). Obviously, there’s a risk here. The price of the partnership units could decline, cutting into the value of your stock dividends. However, both Enbridge and Kinder Morgan have compiled good long-term growth records (especially Kinder).

Until you sell EEQ or KMR, your distribution units accumulate tax-free. In the meantime, there’s nothing to report to the IRS, except any fractional distribution units your broker may choose to sell instead of crediting to your account.

KMR’s implied yield stands at 7.3%. EEQ’s implied yield, based on the value of the current quarterly stock distribution, is 7.5%. Where else can you earn such high yields on a tax-deferred investment in a multi-billion-dollar energy enterprise?

Since they generate zero taxable income, both EEQ and KMR are suitable for IRAs. Because of tax complications, traditional MLPs should be held outside an IRA (i.e., in a taxable account).

Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk value approach has won nine Best Financial Advisory awards from the Specialized Information Publishers Foundation.


Article printed from InvestorPlace Media, https://investorplace.com/2014/04/mlps-amlp-kmr-eeq/.

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