How To Earn Extra Income Now By Owning MLPs During Rough And Fearful Market Conditions?

Amrut Patil
DataDrivenInvestor
Published in
9 min readMar 19, 2020

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Let me guess. One of the reasons you might be reading this article is because you want a safe and stable source of reliable income by paying low or no taxes. You dream about financial independence and would like to take actionable decisions which have a significant impact on your financial future.

Have you seen those giant pipelines while driving along state highways which transport oil and natural gas? What if I told you that they also transport tons of cash to investors who own them? Yes, you read that right. I will show you how you can tap into this cash and get an extra paycheck every month. No, you don’t have to talk to people in the oil pipeline industry. You can earn this cash while sitting at home.

In this article, I will explain how you can earn extra income now by owning such assets and build generational wealth through Master Limited Partnership (MLP). By gaining knowledge about investing in MLPs , you will be among those few smart investors who are way ahead of others in achieving financial freedom early. These are those hidden financial instruments which no financial advisor would recommend since they are boring. But when it comes to reliable stream of income and generational wealth building, you probably don’t care if they are boring as long as the paychecks keep coming.

Let’s get started.

What is a Master Limited Partnership (MLP)?

Master limited partnerships (MLPs) are a business enterprise that exist in the form of a publicly traded limited partnership. They combine the tax benefits of a private partnership, i.e. profits are taxed only when investors receive distributions, with the liquidity of a publicly-traded company.

A master limited partnership trades on national exchanges. MLPs are situated to take advantage of cash flow, as they are required to distribute all available cash to investors. They can also help reduce the cost of capital in capital-intensive businesses, such as the energy sector.

Source: MLPs

Types of MLPs

MLPs have two classes of partners:

  • Limited partners are investors who provide capital for the entity’s operations by purchasing shares in the MLP. Typically, every quarter they receive periodic distributions from the MLP. Limited partners are also known as silent partners.
  • General partners are the owners who are responsible for managing the day-to-day operations of the MLP. They receive compensation based on the partnership’s business performance.

Why Invest in MLPs?

Source: Natural Gas Pipelines

MLPs may not work for all investors. Following are some of the considerations you should make before buying MLPs:

Advantages

MLPs are known for offering slow investment opportunities. The slow returns stem from the fact that MLPs are often in slow-growing industries, like pipeline construction. This slow and steady growth means MLPs are low risk. They earn a stable income often based on long-term service contracts. MLPs offer steady cash flows and consistent cash distributions.

The cash distributions of master limited partnership usually grow slightly faster than inflation. For limited partners, 80%-90% of the distributions are often tax-deferred. Overall, this lets MLPs offer attractive income yields, often substantially higher than the average dividend yield of equities. Also, with the flow-through entity status and by avoiding double taxation, it leads to more capital being available for future projects. The availability of capital keeps the MLP firm competitive in its industry.

Further, for the limited partner, cumulative cash distributions usually exceed the capital gains taxes assessed once all units are sold.

There are benefits for using MLPs for estate planning, as well. When unitholders gift or transfer the MLP units to beneficiaries, both will avoid paying taxes during the time of transfer. The cost basis will readjust based on the market price during the time of the transfer. Should the unitholder die and the investment pass to heirs, their fair market value is determined to be the value as of the date of death. Also, earlier distributions are not taxed.

Disadvantages

One disadvantage to being an MLP limited partner is that you will have to file the infamous Internal Revenue Service (IRS) Schedule K-1 form. The K-1 is a complicated form and may require the services of an accountant, even if you did not sell any units. Also, K-1 forms are notorious for arriving late, after many tax preparers thought they had completed their taxes. Also, as an added problem, some MLPs operate in multiple states. Income received may require state tax returns filed in several states, which will increase your costs.

Another tax-related negative is that you cannot use a net loss, more losses than profit, to offset other income. However, net losses may carry forward to the following year. When you eventually sell all your units, a net loss can then be used as a deduction against other income.

A final negative is limited upside potential, historically, but this is to be expected from an investment that is going to produce a gradual yet reliable income stream over several years.

Tax Treatment on MLPs

Source: Taxes

An MLP is treated as a limited partnership for tax purposes. A limited partnership has a pass-through, or flow-through, tax structure. This taxing method means that all profits and losses are passed through to the limited partners. In other words, the MLP itself is not liable for corporate taxes on its revenues, as most incorporated businesses are. Instead, the owners, i.e. unitholder investors, are only personally liable for income taxes on their portions of the MLP’s earnings.

This tax scheme offers a significant tax advantage to the MLP. Profits are not subject to double taxation from corporate and unitholder income taxes. Standard corporations pay corporate tax, and then shareholders must also pay personal taxes on the income from their holdings. Further, deductions such as depreciation and depletion also pass through to the limited partners. Limited partners can use these deductions to reduce their taxable income.

At least 90% of the MLP’s income must be qualifying income for the MLPs to maintain pass-through status. Qualifying income includes income realized from the exploration, production, or transportation of natural resources or real estate. In other words, to qualify as a master limited partnership, a company must have all but 10% of its revenues be from commodities, natural resources, or real estate activities. As a result, MLPs can only operate in limited number of sectors.

Quarterly distributions from the MLP are not unlike quarterly stock dividends. But they are treated as a return of capital (ROC), as opposed to dividend income. So, the unitholder does not pay income tax on the returns.

Most of the earnings are tax-deferred until the unitholder sells their portion. Then, the earnings receive the lower capital gains tax rate rather than at the higher personal income rate. This categorization offers significant additional tax benefits.

How To Know If An MLP Income Is Safe?

As with any high yield securities, you should perform careful due diligence to ensure that MLP distributions are sustainable. Chasing yield without studying payout ratios is one of the few surefire ways to destroy capital.

The safety of an MLP’s distribution can seen by looking at a partnership’s distribution coverage ratio, which is defined as the ratio between an MLP’s distributable cash flow and its total distributions paid.

  • A distribution coverage ratio above 1.0x means that the company is paying out less than its total distributable cash flow. These distributions are sustainable.
  • A distribution coverage ratio of exactly 1.0x means that a partnership is paying out precisely all of its distributable cash flow. These distributions are sustainable but should be watched closely.
  • Similarly, a distribution coverage ratio below 1.0x indicates that an MLP’s distribution is unsustainable. These distributions are not sustainable and should be watched very closely.

Sometimes, a company can experience a temporary downturn in its distribution coverage ratio without cutting its dividend. Qualitatively assessing the company’s financial reports and management conference calls can help determine the true danger of a distribution coverage ratio below 1.0x.

Distribution coverage ratios are often reported with the company’s quarterly financial release, but if not, are easy to calculate manually.

Should You Still Own MLPs?

Source: Thinking

Tax-exempt institutional investment funds such as pensions, endowments, and 401(k) plans are restricted from owning MLPs because the cash distributions received are considered unrelated business taxable income (UBTI), income that is unrelated to the activity that gives the fund tax-exempt status. This could create a tax liability on any distribution of more than $1,000. This is also true for individuals when holding MLPs in an IRA account, therefore, the best way to hold them is in a regular brokerage account.

Individual investors are the principal owners of MLPs. Because few individuals know much about their structure and complex tax implications, they are often purchased for individuals by private-client wealth managers, although this need not be the case. As long as the individual understands how to manage the K-1 statement and cash distributions, this investment can be perfect for an investor seeking current income and tax deferral.

Useful Resources To Find MLPs

The following website lists MLPS and Funds traded on U.S. Exchanges:

https://eic.energy/current-mlps-and-mlp-funds/

Things To Remember

  • A master limited partnership (MLP) is a company organized as a publicly traded partnership. MLPs combine a private partnership’s tax advantages with a stock’s liquidity.
  • MLPs have two types of partners, the general i.e. managers, and the limited i.e. investors.
  • Investors avoid double taxation by receiving tax-sheltered distributions from the MLP.
  • MLPs are considered low-risk, long-term investments, providing a slow but steady income stream. They can be good vehicles for estate planning.
  • MLPs are limited to the natural resources and real estate sectors.
  • The best way to hold MLPs is in a regular brokerage account.

References

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Other Investing Articles by me

Disclaimer

The content in the above article is for information and educational purposes only. It is not intended to be investment advice. Also, I have no business relationship with any company whose stock or ETF is mentioned in this article. Please consider the risk involved and your personal financial situation before investing or seek a duly licensed finance professional for investment advice.

About me

Amrut is a Full Stack Software Engineer who is passionate about software development and investing. He regularly writes for popular publications like The Startup, Noteworthy — The Journal Blog, HackerNoon.com, Data Driven Investor and codeburst.io. He likes to write about technology, coding, investing, trading, finance, and economics. In his free time, Amrut likes to understand different financial instruments for investing. He strongly believes in adding value to people’s lives through quality work and empower people to take control of their personal finances.

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