How to Invest in MLPs, Part One

How to Invest in MLPs, Part One

This is a two-part introduction to the Master Limited Partnership. Read How to Invest in MLPs, Part Two.

The past few years have been awfully hard on income investors. You’ve watched as the stock market has recovered all of its losses from the great recession, and meanwhile your bond portfolio has not only generated a paltry yield, but at the same time has been losing money as interest rates have begun to increase.

Well, conservative income investors, take heed: there are alternatives to bonds.

Dividend-Growth Stocks

I’ve been a fan of dividend companies for quite a while, and I’ve been analyzing them for months, picking through metrics and choosing what I feel are the best companies to invest in.

I really love dividend-growth companies, which are a sub-sector of the genre and which have to meet a particular list of criteria – ones that are consistently paying and growing their dividends at a rate that far outstrips the rate of inflation. When you select this type of company, you’ve chosen one that is likely to reward you with both a healthy, growing dividend, and a terrific chance for share-price growth as well.

And research has shown that dividend-growth companies have generated better returns than the S&P 500, over many different types of markets. Dividend stocks tend to fare better in downturns than ordinary stocks, and they also do better in bull markets.

But there’s something even better…

You may or may not have heard about MLPs (Master Limited Partnerships). You may or may not know that they are generally associated with energy companies, and that they can have complicated tax consequences. These facts might have been enough in the past to convince you that they are risky and too complex for your taste.

Well, I’m here to show you that none of those things are true. Well, they’re associated with energy, that’s true. But everything else is not.

What are MLPs?

First of all, an MLP is not actually a company. It’s a partnership, as its name implies. There is a general partner, which is usually a large energy company; and there are limited partners, which is what you would be. This “partnership” issue is an important distinction, as you will see in a few moments.

An MLP is formed when the energy company spins off some of its business, generally its pipelines, as a separate entity. The energy company retains control, as the general partner, and offers the limited partnership opportunity to other investors. The general partner may or may not be a publicly traded company, but it really doesn’t matter for you.

The fact that you are a limited partner means that your activity in the organization is limited to the amount of money that you have invested. You are not considered a material participant in the organization, you have no management responsibility, and no liability other than what you invested.

Tax Advantages

The partnership structure of the organization confers several important tax advantages, which is one of the big reasons why investors favor these vehicles.

Firstly, a partnership is not taxed at the corporate level, as a company is. The partnership has only pass-through income, which means that all of the income is passed-along to the investors without being taxed. It is only taxable to you, the investor, at your individual tax rates. In that way, an MLP’s income is not double taxed, like the dividends from a corporation are double taxed – once at the corporation’s tax rate, and then once again when you report your dividends on your individual income tax return.

What this can mean in concrete terms is more money for distributing to partners. If the MLP can avoid paying 20% in corporate income taxes, then there is 20% more money available for distribution. This is one reason that MLPs tend to pay out more than an ordinary dividend-producing stock.

This is why many MLPs pay out in the range of 4 to 6% on a regular basis. It’s not uncommon to find some that pay even higher.

The second tax advantage is the way an MLP’s distributions are calculated. A large part of the distribution to the limited partners is actually composed of depreciation and other costs, which is considered return-of-capital. In that way, your distribution is composed partly of income (taxed at a regular rate) and partly of return-of-capital, which is not taxed upon receipt. Return-of-capital reduces your cost basis, so you will not incur any taxable event until you actually sell your shares. At that point, you will be paying tax on capital gains, instead of a tax every quarter on your distributions.

So the bottom line is, an MLP pays out a high amount of distributions every year, and most of its distribution tends to be tax-free. What’s not to love?

Continue reading in How to Invest in MLPs, Part 2, where we’ll take a look at some practical advice on what not to do with MLPs, and some criteria to use in evaluating them.

Karin Hernandez has been interested in personal finance since she began reading Money magazine in high school. Over the years, she has traded stocks, IPOs, options, futures and forex. She became a freelance financial writer in 2012, and currently writes stock market analysis for The Motley Fool and Seeking Alpha, as well as financial blog posts and articles for numerous private clients. She now totally believes that dividend-growth companies are the best way to invest.

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