Master limited partnerships offer good income opportunities for retirees.
From a tax standpoint, however, the MLP structure is a bit complicated. It comprises a general partner who operates the business and limited partners who provide the capital. Limited partnership units can be purchased on major stock exchanges by investors.
MLPs are also referred to as publicly traded partnerships.
The Internal Revenue Code generally requires that MLPs produce at least 90% of their income from certain natural-resource-related activities. As a result, MLPs tend to operate in natural-resource industries, which can include the transportation, mining, exploration, storage and marketing of these resources.
As a unit holder, the investor is entitled to certain distributions from the operating entity. Although income distributions vary with specific entities, it is common in today’s environment to find many MLPs with yields of between 6% and 8%. MLPs can serve as a good source of cash flow to compliment lower-yielding equities and bonds for retirees looking to take distributions of 4% to 5% of their investment portfolios per year.
Not only do MLPs provide higher current distributions, those distributions tend to grow over time as the company’s earnings grow. While distribution growth rates are by no means guaranteed, even a modest growth rate of 3% may provide retirees with a 6% to 8% inflation-adjusted income stream.
Furthermore, a certain percentage of the annual distribution is often treated as a return of capital and thus is not subject to current income tax. This provides for a higher after-tax yield that can help boost retirees’ disposable income. Eventually, when the units are sold, those deferred distributions are “recaptured” and subject to income tax, but that may be many years down the road.
So the good news is that MLPs offer retirees the opportunity to receive 6% to 8% inflation-adjusted distributions, with a portion of those distributions being tax-deferred.
Caveat
But there is a catch: MLPs have additional tax compliance costs.
The main reason MLPs can offer greater income distributions is because they are not subject to income tax as an entity. For tax purposes, MLPs are considered pass-through entities — the income, gains, losses and deductions at the entity level are basically passed through to the individual partners. Without an entity-level tax, there is more cash flow available for distribution to unit holders.
As pass-through entities, investors in MLPs receive Schedule K-1 instead of Form 1099. The K-1 is a report that itemizes the investor’s share of income, gains, losses, credits and deductions. Those tax items are then separately reported by each unit holder on his or her tax return.
While many MLPs have excellent investor websites with a great deal of tax information, it can be intimidating for investors to handle the K-1. Hence, most investors will need the assistance of a professional tax preparer if they are investing in MLPs. The tax assistance of course creates an added cost for the investor. But the cost should be more than offset by the additional income and tax-deferred nature of a portion of the distributions.
Since MLPs are not subject to income tax, there are additional restrictions with respect to holding MLPs in tax-deferred accounts such as individual retirement accounts. Essentially, if the MLP is not paying tax on the income and the individual retirement account gets to defer tax on all of the distributions, the taxpayer will be receiving a double tax benefit.
Therefore, MLPs held in IRAs receive special tax treatment. If an MLP is held within a tax-deferred account, the investor must calculate what is called the unrelated business taxable income of the MLP. If the UBTI exceeds $1,000 in a tax-deferred account, the excess generally is subject to tax. Because of the complexity of the calculation and the additional tax, it is best to avoid holding an MLP in an IRA.
If you are looking for an alternative source of cash flow for retirees, MLPs are attractive options even with the added tax compliance costs.
Charles J. Farrell, J.D., LL.M., is an investment adviser with Northstar Investment Advisors LLC in Denver.
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