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By Jeremy Glaser | 03-14-2011 06:09 PM

What You Need to Know About MLPs and Taxes

Morningstar StockInvestor editor Paul Larson discusses what investors should keep in mind when buying MLPs, plus an MLP stock pick to consider right now.

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. Its Tax Relief Week here at Morningstar and one area where many people need help is with master limited partnerships or MLPs.

I'm here today with Paul Larson. He is Editor of Morningstar StockInvestor to take a closer look at the structure and see how it could fit into your portfolio. Thanks for joining me, Paul.

Paul Larson: Thanks for having me.

Glaser: So, can you talk a little bit of how an MLP differs from a regular corporation that you would buy, a regular C corp.?

Larson: Sure. MLPs simply stands for master limited partnership and as the name implies, when you are buying an MLP, you are buying a portion of a actual partnership. And this differs from a C corporation when you buy stock, you are getting shares or proportional ownership stake in the corporation. But the primarily difference between the partnership and the corporation is really the taxable structure.

In the MLP, the partnership is essentially a pass-through entity and the partnership or the company's income or losses flow through to the individual owners of that partnership. Where in into the corporation structure, you have a double taxation situation where the corporations do pay corporate income tax and then when they pay out dividends, the owners of the corporation pay taxes yet again.

Glaser: So, if you are an investor and you bought an MLP, when you get to April 15th rolling around, what's going to be different from if you just owned a regular share of a company?

Larson: Well, when you own a regular corporation and you received dividend, you get the Form 1099 from your broker. On the other hand, if you own a MLP, you are going to get what is called a K-1 Form directly from the partnership that you own and this K-1 Form is it's much more detailed than the 1099. 1099 usually it's just one number for each company that you own. But the K-1 may have a dozen data points on there, including your proportional share of the company's revenue and income capital accounts so on and so forth.

Glaser: It might seem tempting to eliminate some of this tax complexity and maybe hold it in a qualified account like an IRA. Are there any reasons why investors shouldn't go that route?

Larson: Absolutely, there is one thing to remember it is that these are tax advantaged investments and therefore it makes the most sense to have these in a taxable account, so that investors get the benefit of the taxable structure. But then also there are some important reasons why you wouldn't want to own these in a qualified account like an IRA or 401(k).

One is that, and the most important one in my opinion, is that you could actually owe taxes from within your IRA or the 401(k) if you own a sufficient amount of these MLPs. If you have over $1,000 in UBTI or unrelated business taxable income, which is what partnership income is considered, your IRA or 401(k) account could actually end up owing taxes. So, I think that's a pretty important reason for shying these towards your taxable account.

Glaser: Instead of eliminating complexity, you might be adding a bunch of complexities that you didn't anticipate?

Larson: Absolutely, and then of course, you would be forgoing the tax benefits of these investments. One tax benefit is that for the vast majority of MLPs, the taxable income that is generated by this investment is far smaller than the actual distributions that these companies pay out. So, you might get $1,000 in distribution and not have to pay any taxes on it whatsoever. And of course, that difference will have to be paid in taxes at some point down the road. But you as an MLP owner can defer that as long as you don't sell, you are not going to pay that difference or that return on capital.

Glaser: So, for investors that understand the tax consequences and hold it in taxable account, do you have any suggestions of MLPs that they might want to look at right now?

Larson: Sure, one that looks attractive to me is a company called Energy Transfer Equity and this is structured as an MLP and it is actually the owner of the general partner stake of another MLP called Energy Transfer Partners. But the bottom line with ETE today is, here we have a MLP that is yielding in excess of 5%, and we think that the distribution growth is going to be close to 15% over the next five years. And the reason for this is they have two major projects about to come online that should increase the company's cash flow on the order of 20% to 25% once the projects actually come online. And they are in the process of coming online as we speak.

Glaser: Paul, thanks for speaking with me today.

Larson: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.

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