Investors tend to behave like manic-depressive zombies.
They get overly excited when news brightens, and they despair at the first whiff of negativity. They blindly march in one direction, only to eventually execute a 180-degree pivot.
Although energy master limited partnerships have regained their luster lately, don't blindly jump in. Investors need to re-familiarize themselves with their pros and cons.
Let's look at MLP income opportunities as well as their tax ramifications.
When investors put money into an MLP, they become partners, though passive ones. And every penny of an MLP's income, as well as depreciation, new debt, etc., is annually attributed to the partners.
This flow-through means that the income doled out to the partners is chiefly offset by depreciation changes, because most MLPs invest in energy plant and equipment. The upshot is that investors shelter most if not all of their MLP income from taxes.
It is a sweet investment deal, and traders poured into MLPs when oil prices were relatively high, especially when they reached their zenith in 2014 of $80 to $100 a barrel. Then energy prices collapsed, and many MLPs, especially those that had recklessly expanded by taking on huge debt, turned sour.
But now, energy prices appear to have hit bottom, and they are rising again. Prices hover near the $50 a barrel threshold that energy companies need to break even, which is considerably better than the nadir of the $20s reached in February.
But MLPs come with catches.
For example, the income that isn't taxed now will be taxed when a partner sells, at the ordinary income tax rate. Consequently, MLPs offer tax deferral similar to that of retirement accounts, except that partners get payouts every year to spend.
Be mindful of these other key points:
Tax basis. This calculation is crucial to the tax paid in the future. It is predicated on how much a partner initially invested in the MLP, and it is calibrated up or down annually by various types of financial transactions. For example, new MLP debt and investment are proportionately added to the tax basis, but income paid lowers tax basis.
Zeroing out. The tax basis will probably fall over time. Years from now, when or if the basis reaches zero, a partner will forfeit tax-deferral. Every year thereafter, all the payouts will be taxed as capital gains.
Estate and retirement planning. Leaving an MLP to an estate can be a smart move. Upon death, all the income paid out is added back to the tax basis, allowing heirs to inherit a hefty tax deferral. But be leery of investing in an MLP via a 401(k), an individual retirement account or other tax-advantage retirement accounts. Within a 401(k) or IRA, a portion of the MLP's payout may qualify as something that the Internal Revenue Service calls "unrelated business taxable income" and incur a tax liability. The amount that triggers the liability is $1,000 per taxpayer per year. It is also a bad idea to donate MLPs to charity because the deduction is limited to the capital appreciation, not the market value of the shares.
K-1 tax forms. MLPs send out K-1s in February or March. These are longer and more complex than 1099s. All the numbers needed are provided by the MLP, but partners are well advised to hire an accountant to take care of the paperwork burden.
ETFs that invest in MLPs. A notable example is the aforementioned ALPS Alerian MLP ETF. This and other ETFs that are more than 25% invested in MLPs are required by the IRS to structure as corporations. Accordingly, the ETF itself owes taxes each year on any taxable income and any net gains as shares are redeemed. As with corporate dividends, there is double taxation. One benefit is that investors get a straightforward Form 1099 each year, not the more difficult K-1.
Because of the additional layer of taxation, the return on these types of ETFs is lower than that of the MLPs that they hold. And when partners sell, they still pay a tax on any price gains. But that said, the ETFs are diversified and safer than individual stocks.
This benefit is especially salient in light of the debt-ridden and struggling MLP casualties of the energy price collapse, such as Azure Midstream, Crestwood Equity Partners and NGL Energy Partners.
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John Persinos is an editorial manager and investment analyst at Investing Daily.
Persinos appears as a regular commentator on the financial television show "Small Cap Nation." Follow him on Twitter.
At the time of publication, he didn't own any of the stocks mentioned.