With some of the biggest dividends of the stock market MLP partnerships are tempting, but you have to know how to get paid without getting burned.
Partnerships are all about paying stockholders to own them. The whole structure of a partnership is set up to pass through profits right to their owners without imposing corporate income tax costs. Investors are already paying regular income taxes on their dividend income.
Partnerships come in a variety of structures that include limited partnerships (LPs), master limited partnerships (MLPs), general partnerships (GPs) and limited liability companies (LLCs). For my purposes I tend to refer to all of them as publicly traded partnerships (PTPs) or just good old partnerships.
Partnerships have been around in various forms for many years and exist not just in the U.S. market, but in an increasing number of other nations and tax jurisdictions. But it’s been the U.S. that’s been the biggest market for these companies thanks to a massive tax reformation that took place in 1986.
Prior to 1986, partnerships were operating wildly in the U.S. That was thanks to out-of-this-world effective income tax rates for individuals that topped 70% and a loophole in the U.S. tax code. This loophole meant that partnerships could be structured to generate large amounts of tax losses which could then be used not just to offset current dividend income, but also offset active income including salaries and bonuses.
Tax reform legislation changed the code for partnerships and all other pass-through investments. As a result, losses can offset passive investment income.
This brought carnage for those gaming the system prior to the tax reforms. And on top of that, the petrol industry further soured investors that weren’t prepared for the changes.
A Real Partnership
Let’s move forward to our current market. Partnerships have continued to mature and expand, resulting in a great opportunity for investors seeking high dividends from solid cash-generating assets.
The industries that fit the bill for partnerships include a variety of businesses involved in energy production, processing and distribution as well as other major capital asset businesses including infrastructure and transportation.
Energy of course continues to be the biggest part of the U.S. partnership market. This means that you need to be careful not to be too invested — and thus exposed to a potential fall in crude oil, natural gas or coal. Such falls can have quite dire consequences for cash flows, dividends and stock prices.
Partnerships have devastated too many investors, tempting them with super high dividends and then succumbing to market woes. How bad can it be? When a partnership goes under it results in suspended or eliminated dividends, or even worse, bankruptcy.
Partnerships are just like any other stocks that pay you to own them. Each of them has to prove how they’re going to continue to be profitable with market downturns including the current downdraft of lower crude oil prices.
And then they have to prove how each will be able to continue to finance their debt.
Taxes Get Paid One Way or Another
Before I get to some of my favored partnerships, I need to go through how the taxes work on these partnerships.
As noted above, partnerships are structured as pass-through investments. Partnerships earn profits and then pass them through to pay shareholders. That process happens before the partnership pays federal or state taxes.
This helps avoid the dreaded double taxation challenge that impacts dividends paid by ordinary common stocks. But it comes with some additional benefits as well as some pitfalls.
To start, let’s look at the benefits. Not only do you as an investor in a PTP get paid more by not having the PTP pay taxes before you get your cut, but the PTP gets to also pass through depreciation and other costs which is listed as return of capital.
The result is that for the dividends paid by PTPs, much of the cash is actually deemed as return of capital and not actual earned income. This means that investors aren’t liable for income taxes on much — or in some cases all — of the dividend income.
But the return of capital then must be used to reduce your cost basis for your investment in the PTPs. So, when you sell, you’ll pay taxes on the capital gains that you’ve had. But you won’t have to pay until you sell. So, at worst, you’ll defer your tax bills and perhaps, just maybe, you might pay at a lower tax rate for the gains.
However, there is a hidden benefit here. If you die before selling, the shares’ cost basis is reset to the current market, so the tax bill goes to nill. But of course you have to die to get this benefit, so there is some cost.
Partnerships and Retirement Accounts
One more limitation concerns qualified retirement accounts that hold partnerships. IRAs, SEPs and other plans can hold PTPs, but these are not the most tax-efficient accounts to get the full tax benefits of the partnership structure.
And if you own too many of these PTPs inside a qualified account you could owe taxes as unrelated business taxable income (UBTI). The tax code establishes that somebody will eventually have to pay taxes on income, even income generated by partnerships.
This means that since most income paid by a PTP is return of capital, UBTI limits won’t kick in for the vast majority of the dividend income paid by partnerships.
K-1s Are OK
PTPs don’t pay any tax at the corporate level on qualified activities. Instead, quarterly distributions are passed directly to unitholders. (If you’re unfamiliar, a unitholder is an investor who owns one or more units in an MLP or investment trust). Investors pay individual taxes on their distributions. But PTP distributions are highly tax-advantaged and offer a significant tax shield.
Because many PTP distributions aren’t dividends, unitholders don’t get a 1099 form at tax time. Unitholders receive a K-1, a standard form typically mailed in February.
There are some big tax benefits to owning PTPs. Specifically, due to depreciation allowance, 80%-90% of the distribution you receive from a typical MLP is considered a return of capital by the IRS. You don’t pay taxes immediately on this portion of the distribution. Instead, return of capital payments reduce your cost basis in the particular PTP. You’re not taxed on the return of capital until you sell the units, which means, at worst, that you get to defer taxes for years to come.
And there are other ways to invest in PTPs while completely avoiding these tax considerations. There are exchange-traded funds and closed-end funds which invest in PTPs. The benefit of buying these funds is that all of the K-1 forms and cost basis calculations are handled by the fund manager, and fund holders simply receive a 1099 at tax time.
In other words, all the income passed through from the PTPs held in the fund is considered dividend income. You pay taxes on these distributions as you would for any other dividends. And funds help avoid a rare potential additional tax on some qualified investment accounts and plans, unrelated business tax income (UBTI).
3 MLPs and an ETF Alternative
MLPs in the U.S. are largely focused on the petroleum market. And the market for crude and natural gas has been facing challenges since summer 2019. After a bit of a respite in December and early January, the market has taken it on the chin again thanks to the fallout from the coronavirus (2019 n-CoV).
The argument goes that as the virus leads to less production of goods and services as well as restricted travel in Asia, that demand for crude oil and natural gas will drop, depressing demand and resulting in lower prices.
That said, China only buys 200,000 barrels per day (bpd) of crude from the U.S. — but it does make up 13% of global consumption of crude.
But the key to remember is that MLPs in the U.S. petroleum market are largely focused not on production, but on pipes, terminals and storage facilities. These are less at risk for oil and gas pricing than producers or refiners.
But pipeline MLPs do have to deal with counterparty risks. This means that they have to manage the risks that their contracted producers and contracted consumers of petroleum will be able to stand up to their contracts. Because if they don’t, then pipes go idle and so too shall cash flows for revenues.
The three MLP pipelines below each have been in the markets through thick and thin. So, they have proven their ability to deal with counterparty risk.
MLPs to Buy: Enterprise Products Partners (EPD)
Enterprise Products Partners (NYSE:EPD) has a vast network of natural gas, crude oil and other petroleum-related pipelines. Despite the challenges in the markets, revenues are still ample. EPD brought in $8 billion for the recent quarter.
It is efficient in its operations, with operating margins running at a fat 18.5% which in turn works to deliver a return on equity of 20.1%. With ample cash and debts manageable at 46.2% of assets, Enterprise is a capable company.
And it is a value as the shares are at a mere 2.4 times book value and only 1.8 times trailing revenues.
The dividend distribution is running at 44.5 cents for a yield of 6.8%. And those distributions continue to rise by an average annual rate of 4% over the past five years.
Investing in quality MLPs is all about buying and owning for the longer term for income and gradual gains. And Enterprise has proven to be a longer-term performer.
The shares have returned 197.7% over the past trailing ten years for an average annual equivalent return of 11.5% per year.
Plains GP Holdings (PAGP)
Plains GP Holdings (NYSE:PAGP) is the general partner of Plains All American Pipeline (NYSE:PAA). As the general partner it has the controlling interest and ownership in Plains All American. And PAA has a massive collection of terminals, storage and pipe for crude oil, natural gas and refined products.
Plus it is one of the primary pipelines for core U.S. shale production in the Permian Basin.
Revenue is strong with the most recent quarter showing over $9 billion. And that revenue has been gaining over the past five year by a compound annual growth rate (CAGR) of 9.5%.
The operating margin for the general partner is more modest at 5.9%, but the return on shareholder’s equity is ample at 16.5%. And cash is on hand and debts are low at only 31.9% of assets.
What’s more, the stock is a big bargain as it is valued at a 90% discount to the trailing revenues of the company.
Given the focus on crude oil from the Permian, the stock market hasn’t been too keen to provide a better valuation for the share. This shows in the price-to-revenue ratio of 0.1.
And the shares are newer to the public market, so the trailing four years have only resulted in a return of 13.1%.
The distributions are running at 36 cents per share for a yield of 8.3%. And the distributions are up by 20% over the past year. All of the distributions are fully shielded from current income tax liability, making them worth even more.
Magellan Midstream Partners (MMP)
Refined products are where there are better stories. Marine fuel standard changes are providing opportunities for pipes, storage and marine terminals.
And that also extends to diesel, gasoline and jet fuels.
This is why Magellan Midstream Partners (NYSE:MMP) is a prime pick for me. MMP calls Tulsa, Oklahoma home, and it deals with refined products. Revenues continue to climb with the compound annual growth rate over the past five years running at 7.3%. And operating margins are a whopping 44.1%, which in turn delivers a return on equity of 40.2%.
Dividends provide a yield of 6.8% and the distributions are rising, with the five-year annual average running at 9.1%. And MMP has returned a positive 373.3% over the past ten years for an average annual equivalent return of 16.8%.
ETF Alternative: Alerian MLP (AMLP)
For investors wanting to gain the income and longer-term growth of MLPs without K-1 tax forms, there is the Alerian MLP ETF (NYSEARCA:AMLP). This ETF has the three MLPs as primary synthetic holdings in the fund.
The ETF hasn’t been gaining investor attention because the MLP space has been challenged. This means AMLP is a bit of a bargain.
But for those that do like to buy a bargain, you’ll be well paid. The dividend is running at 19.5 cents for a yield of 9.5%. And this ETF works for those seeking to avoid K-1s.
Neil George was once an all-star bond trader, but now he works morning and night to steer readers away from traps — and into safe, top-performing income investments. Neil’s new income program is a cash-generating machine … one that can help you collect $208 every day the market’s open. Neil does not have any holdings in the securities mentioned above.
