MLP Investment Guide: Quantifying Tax Benefits v.s. K-1 Headache
Updated on August 17th, 2020
Pipelines and ships that transport oil and natural gas from the source in the ground to the processors and end users form a particular subset of the energy industry known as mid-stream assets and are usually structured as a Master Limited Partnership (MLP).
What are Master Limited Partnerships?
The Master Limited Partnership structure is a pass-through vehicle where income, depreciation and taxes flow through to the unit-holder (the name for a shareholder in a LP) and all these items are provided to the investor on a K-1 tax form at the end of the year.
In this article I discuss the unique benefits and taxes on master limited partnerships and show that the tax benefits are worth the tax accounting and reporting compliance costs, if certain conditions are met. I also discuss why MLPs are the cheapest they may have ever been.
Currently The Energy Industry is Cheap, Extremely Cheap
The whole sector is under strain right now. MLPs are a contrarian play and the goal is to find the select names that will survive and greatly reward shareholders through the carnage. The time to buy assets is when everyone else is getting out of them at any cost and is not willing to wait for better times. Pipelines are not going away. When the future looks bleak, assets are cheap.
Let’s discuss why their prices are so low right now.
Low Commodity Prices
In April 2020, the front month futures contract for delivery of crude oil actually went negative, very negative:
This has never happened before in the history of oil markets. For an exploration and production (E&P) company, which a midstream MLP provides transport services to, it is hard to make a profit with super low commodity prices. There is great pressure to cut production if it is not profitable to remove it from the ground. This is bad for an MLP because their business is fee based on how much they transport.
MLPs are feeling the blunt of a double whammy of supply and demand shocks at the same time.
Even before the COVID-19 crisis, electric cars were becoming popular and fuel mileage standards were being raised every few years. Population growth has blunted the effects of both of those headwinds.
But now due to the virus, commerce and tourism have all come to a grinding halt around the world. Planes aren’t flying, people aren’t driving, and cruise ships have become floating quarantine zones. The EIA and others are forecasting a rare drop in oil demand across the globe for 2020.
While most MLPs are pipelines and are not directly dependent on the price of the commodity they are transporting through their veins, they aren’t quite the “toll-road model” that many people got suckered into believing all the way up until the end of 2014.
They can never be fully insulated from the price of the commodity when the price a producer gets and the amount of driving and flying a consumer uses determines how much of the commodity is flowing through the pipeline. If a producer cannot make money with current prices, they will cut production and if a consumer is working from home for months on end, they won’t need to take gas out of a gas station. In both cases it means fewer fees can be charged by the midstream MLP that serves as the connection between the two parties (plus refineries along the way).
While many MLPs do have “take-or-pay” or “make-whole” contracts, which on paper guarantees a level of profit regardless of how much commodity flows through the pipeline, these guarantees have little value if the contracted party declares bankruptcy or the contract has to be fought in court over several years.
Self Inflicted Wounds Of Debt
MLPs have historically paid out all cash flow that they brought in and would finance their operations with additional secondary offerings and issuance of debt as needed. This is in contrast to regular companies when after they become profitable, start to finance their operations with retained earnings.
Investors got a wake-up call at the end of 2014 when commodity prices plummeted and found these firms were just way too debt heavy for the yield they were providing to investors. Correspondingly, the prices plummeted and yields rose.
We are witnessing a round two of that situation now with commodity prices making many E&P’s unprofitable. There is no general rule about what happens to the midstream MLP if its upstream suppliers declare bankruptcy. It would depend on how many of their suppliers were affected and whether the upstream operations continue during the bankruptcy proceedings.
There is no doubt that many upstream shale producers will go belly up this time around because they gorged on debt when times were good and have been struggling with low commodity prices ever since. Much of the ongoing operations are just not sustainable.
Environmental, Social, Governance (ESG) and Index Investing Impact
Index funds work by buying a proportional representation of the largest companies. The larger a company is, the more money it has allocated to it in an index fund. As more money flows into a company from active funds and individual investors, the market cap grows and needs to be reflected in the index. Therefore the index fund buys more of that company, creating somewhat of a self-fulfilling prophecy of capital allocation.
Even before the COVID-19 crisis caused a bunch of supply and demand issues for the firms, the impact of ESG investing was having an impact on the energy industry. Fossil fuel energy companies are generally frowned upon by ESG mandates and will not allocate capital to them (some mandates choose the least worst instead of not allocating at all). Near the end of 2018, there was $12 trillion of money allocated to these types of funds, proving it is a powerful tide to swim against.
Additionally, with the rise of passive investment in index funds, MLPs have been excluded from the fat trough of retirement money. This is because most pipelines use the MLP structure, and only C Corporations (C-Corps), where the corporation pays taxes as a separate entity, are allowed to be in the S&P 500. Consequently, MLPs aren’t hoovered-up indiscriminately like the FAANG stocks are from standard 401(k) biweekly contributions.
Right now, the energy sector has the lowest representation in the S&P 500 since 1941.
This leaves some of the investment space on the table; some of the highest yielding investment space, in particular.
There are many advantages of the Master Limited Partnership security, but there are some disadvantages as well.
MLPs Are High Yielding Assets
And that’s exactly the thing that makes this area attractive. Yields are easily greater than 7% and lots of them have yields greater than 10%. A lot of investors have been conditioned to fear high yields, but MLPs have higher yields for many reasons, and one of those is because they get special tax treatment, described in more detail later. Unfortunately that special treatment comes at the price of an annoying K-1 tax form each year at tax time.
MLPs Require a Complicated K-1 Tax Form
K-1 tax reporting is one of the largest annoyances about buying partnership structures (MLPs, LPs). MLPs don’t pay taxes, you do. All of the accounting that usually happens at the corporate level gets mailed to you, for you to add to your personal tax return. The K-1 tax form has a lot of boxes that end up in different parts of the individual’s tax return.
Additionally, you are supposed to file a state tax return in every state that the MLP operates in, even if you don’t live in any of those states. Luckily, many states have a minimum income requirement before a filing is required. When you receive your K-1 tax form at the end of the year, they will tell you how much income applies to which state. If you are a smaller investor, you’ll likely be under most limits.
However, it has the potential to be a big tax headache which is why most regular investors pay a game of “avoid MLPs at all costs,” which further adds to their cheapness. Some people just assume that the MLP tax consequences aren’t worth the benefits, which is why I created this article in the first place. The benefits can be quantified.
K-1 Forms Add Costs to Tax Preparation
A typical CPA will usually charge an extra $100 per K-1 form. It takes me about an hour to collect digital copies from the various sources, review, and type the information into my online tax software, which often requires clicking on a dozen drop-downs to choose the correct letter classification for a field.
Typing numbers is not hard, of course, but I find the process to be tedious because the typical MLP form has like 30 fields that you need to type in and re-check since it is very easy to make a transcription mistake. So even if one doesn’t use a CPA, the hassle is not free.
Because of this, many people would rather just skip the process and drop off their forms in a pile and have an tax professional do it for them. I’ve seen an H&R Block in basically every strip mall I have ever been to. The nice thing about them is that they have various levels of professional help services from the do-it-yourself online option, an online with CPA assist option and also the classic in-person filing option.
With that in mind, let’s say that handling each form is worth an extra $100 a year, whether you do it yourself or pay someone else to do it for you.
We can establish that larger investment sizes are better for reducing this relative compliance cost, since the numbers on the form only get bigger but the cost of handling the form stays the same. More precise numbers to follow later.
MLPs Are Not for Retirement Accounts
You might think that you could side step all the master limited partnership tax issues along with the tax form and just invest MLPs in a Roth or regular IRA, but you would be inviting taxation trouble with the Unrelated Business Taxable Income (UBTI). If you exceed the $1,000 limit you’ll have to pay tax on that amount and your IRA custodian will charge you an extra $300 fee for the privilege of filing for you.
Some people try to buy small amounts and keep that income under the $1,000 limit and think they are safe, but upon the sale of the MLP you could potentially blow past that limit without realizing it. The depreciation recapture (discussed below) and the debt financed portion of the capital gains are also subject to the UBTI tax.
Ah ha! You may try to get slick and decide to throttle your sales to only a portion each year to keep you under the limit, but in recent years, a lot of MLPs have started to convert their structures to C Corps or they have merged or engaged in other corporate transactions, leading to the tax bills to come forth immediately. In that case, it would be totally out of your control and you would get hit with the tax.
The moral of the story is just don’t put an MLP into your retirement account. Only after an MLP has converted to a C-corp, which sends a 1099 to your broker each year, can you consider putting them there. The whole point of the MLP structure is for the unique tax benefits.
MLPs are not for ETFs
There are several master limited partnership ETFs and ETNs in existence such as AMLP but the problem is that these funds collect the K-1 forms and pay taxes at the corporate level and then issue you a 1099. You might think that is great, but this leads to a tax drag on return every year since you are being taxed on the asset twice, just like a C-corp.
For example, back in the early 2010’s when MLPs were really running hot, the performance spread between the Alerian MLP ETF and ETN was a 40% deficiency over 3 years.
There are some master limited partnership funds structured as a pass through where you receive the K-1 forms at the end of the year, but this has the potential to be a nightmare deluge of dozens of forms you are required to file, each one incurring a separate fee (or handling charge). And since most funds stick to a benchmark, you will end up with a lot of junk you’d probably rather not own anyway.
Now our discussion turns to the benefits of MLPs and why you want the K-1 taxation method.
MLPs Have Tremendous Tax Benefits
The main attractant is the cash flow that these real assets generate and these distributions are not qualified dividends. The tax treatment is very different, and how much an MLP can pay unit-holders is known as Distributable Cash Flow (DCF). The following 3 factors are the major tax benefits that accrue to MLPs.
Depreciation is one of the largest benefits for owning a Master Limited Partnership and it is one of the least understood factors of taxable income for the energy industry by laymen.
Depreciation is a non-cash charge against earnings, which accounts for the fact that depreciating assets have a limited life, and not all the money that is made from that asset is actually profit. It is usually spun as a tax subsidy, but metal wears out and needs to be replaced at some point, usually decades in the future. The depreciation spreads that amount across the projected life of the asset.
Therefore, similar to owning a real estate investment property, most of the distribution (i.e. dividend) of an MLP is not immediately taxable because it is considered return of capital (ROC). This lowers your cost basis and this depreciation is paid back, or “recaptured,” at ordinary income rates when you sell, hopefully years later.
As discussed in my traditional 401(k) article, I advocate for receiving tax breaks now while your tax rate is higher during your working years.
The ROC depends on the specifics of the MLP, but it is often about 80% of the distribution. If you have held an MLP for a very long time (+10 years generally), your cost basis will go to zero (the lowest it can go) and you will pay ordinary income rates on the part that doesn’t qualify for the Qualified Business Income (QBI) deduction.
Qualified Business Income Deduction
Which brings me to the probably the best feature of investing in MLPs. The Tax Cuts and Jobs Act of 2017 signed into law the QBI and it means that partnerships and other pass-through entities, like REITs, get a 20% deduction of their income. This reduces the tax rate on the income you receive and reduces the depreciation recapture when you sell! The higher your marginal tax rate, the more valuable a MLP structure is to you.
So for example, if an MLP has a 80%/20% depreciation/income mix and you are in the 32% tax rate, your effective tax rate for current year’s distribution is only 5.12% (32%*20%*80%)!
The 20% deduction law is set to expire on Dec. 31, 2025 which means that the reduction on income and depreciation recapture might not exist for your entire holding period if a future Congress doesn’t renew the tax break within the next few years. I include it here in my analysis because it is currently law and usually Congress renews laws of this type, but if it isn’t renewed, the benefit to holding MLPs will be reduced somewhat.
Stepped Up Cost Basis Upon Death
The longer it is deferred, the longer that inflation eats the value of the depreciation recapture you will have to pay back when sold. That deferral is potentially indefinite if you die and pass the asset to your heirs. They will get the stepped up cost basis on any capital gains and the depreciation recapture bill goes away! This makes MLPs another great tool for estate planning while providing you with large cash flow stream in the meantime.
MLP Feature Summary
- High yield.
- High percentage of the distribution is tax deferred.
- QBI 20% deduction on income portion.
- Recaptured depreciation paid back at ordinary income rates upon sale.
- Stepped-up-cost basis upon death.
- Multiple state tax forms need to be filed for large investments.
Master Limited Partnerships Are Not Casual Investments
MLPs Require Homework
MLPs are extremely complicated investments with Incentive Distribution Rights (IDRs), non-controlling interests, asset dropdowns, multiple share classes, DCF coverage ratios, parent sponsor considerations, and different basins or territories (and country laws for ships). These are investments you really have to run through the SEC filings if you are going to have confidence in your investment. Looking at a few ratios really isn’t going to cut it, so if you’ve spent less than two hours on a Master Limited Partnership and have a decision to buy it, you probably haven’t researched it enough.
But once you have done your homework and have narrowed down a good company, then we can apply the considerations for when the MLP structure is preferable.
Wait Until You Can Get a Good Yield (like now!)
In most circumstances, I would say that it would not be worth it to buy into a MLP with a 5% yield or less since there are hundreds of corporations and funds that have similar yield, without the extra paperwork. The point of MLPs is cash flow, so wait until the prices are attractive enough to yield plenty of it (like now in 2020).
With the average MLP yield pushing 10%+, this requirement is an easy hurdle to jump over right now, but it hasn’t always been the case. MLPs were hot 5 years ago when yields were being pushed under 5%, and people were going nuts buying hand over fist! The space subsequently lost more than 50% of its value as a group, so yields have come back.
MLPs Require Commitment
The second consideration is that it needs to be a serious investment with a lot of capital committed and a long time frame to overcome the tax preparation costs and to defer the tax bill as long as possible, respectively.
If you are going to invest $5,000 and make $500, but then have to pay $100 for the K-1 taxation handling resulting in 20% of your cash flow being eaten up by tax paperwork, clearly it’s not going to be worth it. Similarly, if you are going to buy it and sell it within a couple of years (assuming nothing bad materialized forcing the sale) then the value of the tax deferral isn’t going to amount to much.
How much capital should you commit? The tables below show the more and longer, the better. To make it worthwhile, it probably needs to be at least $20,000, but preferably $50,000 to $100,000 per MLP.
And what is a long time frame? At least 5 years, but preferably longer than 10 years.
These two conditions likely exclude most people from putting MLPs into consideration at all. It takes a lot of confidence to invest that much for that long. And frankly, most people don’t hold stocks longer than a single year so it’s hard to imagine a shift to a holding period 10-20 times as long.
Ten years is probably about the longest you would be able to hold onto an MLP due to the fact that the average MLP lifespan really doesn’t seem much longer than that. Plenty have either reorganized or converted to C-Corps, gone through bankruptcy, have been combined into new entities through mergers or have been acquired. Each one of those events is going to make the tax man cometh.
And there is a lot of pressure for MLPs to undergo conversion to C Corps due to the tax compliance burden of investors and for raising capital. The CEOs of the two largest MLPs, Energy Transfer (ET) and Enterprise Products Partners (EPD) own large stakes in their own companies and have expressed desire to remain as MLPs for tax purposes. They could change their minds at any time, however.
So back to the original question, is the taxation and K1 form headache worth the extra yield and deferment? I show quantitatively the answer is yes and this section shows the math as to why. However, you’ll have to make sure you have a MLP with a well covered distribution and not at risk of a bankruptcy. I’m not claiming that every MLP is worth it, I’m just trying to show you the value of two similar assets with different tax treatment, everything else the same.
In the tables below, I show the value of the MLP against two types of assets, a REIT, which is also a pass-through entity that qualifies for the 20% deduction and a C-Corp which has to first pay taxes on its earnings before paying a dividend. The only advantage an MLP has over a REIT is the tax deferral, but for the C-Corp it is the tax deferral, the distributions are not first taxed before being paid out, and the 20% deduction in income.
There are many parameters to adjust and all of them have an impact, so I only show a few cases here.
Say you are a high income earning family in the 32% tax bracket, with a 5% state tax and the MLP is yielding 8%, with a $25,000 investment, 10 year time horizon and inflation of 2% per year. The benefit of the MLP over the REIT, after paying the CPA for the K-1, is about 16 bps (0.16%) per year (shown in Table I). Again, that is AFTER factoring in the $100 a year CPA charge.
But compared to a C-Corp (whose effective yield is then 6.32%) is where MLPs really shine at 53 bps per year, as shown in Table II.
The more you invest, the higher the inflation, the higher the yield on the MLP and the longer the investment term, the more the benefit to the MLP structure.
If we bump the amount invested to $50,000 for a ten year term, I estimate the benefit to be 29 and 66 bps, respectively, as shown in Table III and IV.
Diminishing returns starts to kick in as the amount invested increases and so if the investment is bumped to $100,000, the improvement is then only 35 and 72 bps, respectively.
In the unlikely scenario that you can commit $50,000 for 20 years, after about 15.5 years, an 8% yielder with an 80% depreciation mix will bring the asset’s cost basis to zero at which point your depreciation shield is gone. Therefore, taxes will increase a little.
It’s a subtle, but not huge impact on the numbers. In this scenario, the gain over REITs is 42 bps a year and over C Corps, 68 bps a year.
MLPs Have a Cost Adjusted Benefit
Remember, those extra returns calculated above are AFTER factoring in the cost of the tax preparation, so the tax benefits of the Master Limited Partnership structure adds excess return to the investment. In other words, the advantages of MLPs do outweigh the disadvantages.
If you can invest a decent amount of capital and are willing to commit that capital for many years, the MLP tax benefits outweigh the $100 a year K-1 tax form processing charge that you will either have to pay a CPA to do, or expend the effort filling it into your tax return yourself.
Since volatility is the Achilles’ heel of long-term investments, you might want to consider putting your MLP and other long-term holdings into a separate account that you don’t view that regularly so that you aren’t enticed to sell at a moments notice. Pipelines are real assets, just like houses are, and you don’t check the value of your house every day and consider selling if it has lost value in the short term. MLPs should be treated similarly and only should be sold if a major negative development has impacted the company’s future operations.
Continue reading on the subject of tax deferral, and why you should choose the Traditional 401(k) instead of the Roth 401(k).
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