For the five-year period that ended September 30, 2013, four of 12 major asset classes lost value while eight posted positive total returns. Master Limited Partnerships, an asset class that did not exist a decade ago and mainly invests in oil and gas companies, trounced all asset classes in five-year cumulative returns. What are they?
MLPS are considered an “alternative investment” that can help diversify a portfolio. They combine unusual tax benefits with the possibility of a favorable return. Like other “pass-through” entities, such as S corporations and most limited liability companies, MLPs aren’t subject to corporate income taxes. Instead, MLP partners are personally responsible for their share of an MLP’s income. That eliminates the “double taxation” problem of regular corporations, which are taxed at both the corporate and shareholder levels.
MLPs make periodic distributions to the owners of partnership units, much as a corporation may pay dividends to shareholders. However, MLP cash distributions aren’t guaranteed. And all of the unit holders remain responsible for the taxes on their share of the MLP’s income—even if it isn’t distributed.
Your initial tax basis is the amount that you pay for the units. Subsequently, your basis will be adjusted downward for distributions and upward for allocations of income. Also, a portion of certain distributions may qualify as a return of capital, thereby reducing your basis. When an MLP pays more in distributions than it earns in taxable income, your basis is decreased by the difference between the cash you receive and your share of the MLP’s taxable income. If you sell any MLP units, your gain is taxed at ordinary income rates. (Currently, the top tax rate on ordinary income is 39.6%.)
MLP income must be reported annually to the IRS on K-1 forms, which shows your allocated items of income, gain, loss, deductions, and credits. If you have negative taxable partnership income for the year, it will be treated as a “passive activity loss,” which can only offset income from other passive investments. Thus, the losses may be less valuable tax-wise than other types of investment losses.
Although your personal liability for an MLP generally is limited, creditors may have the right to seek a return of distributions made to shareholders if the liability occurred before distributions were made. That liability remains in place even if you later sell your units.
Because MLPs have been huge outperformers, expect to see more of them. But past performance does not tell you about what will happen in the future. And before you invest, it’s important to understand that MLPs have unusual tax characteristics that suit some tax situations but not all. Plus, they carry the risk of the underlying investment, which may be a good energy deal or not. MLPs are a new asset class to watch—carefully.