MLPs: High-Quality Income Generators

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. With lot of investors searching for yields, MLPs, or master limited partnerships, have become increasingly popular. I am here with Paul Larson. He is Morningstar's chief equity strategist. He is also the editor of Morningstar StockInvestor. He is going to look at why MLPs could be attractive, but also some things to keep in mind. Paul, thanks for talking with me today.

Paul Larson: Glad to be here again.

Glaser: Let's talk about MLPs. They're a little bit different than maybe a standard, so-called C corporations that a lot of investors might be familiar with. Can you talk a little bit about the structure and why people should consider them?

Larson: Sure. I have owned a number of MLPs over the years in the Hare portfolio, in StockInvestor and I was also an energy analyst before managing those portfolios, so I have a little bit of experience in these. And a master limited partnership is basically just a different structure, and what it is, is when you buy the units, or the stock, on the exchange, you actually become a limited partner in the partnership.

And the key difference between an MLP and the C corp. is that now the C corp. pays taxes at the corporate level, whereas the MLP does not pay any taxes at the entity level, at the partnership level. And the partnership's income and losses flow through to the individual owners. So, there are still taxes paid, but it's paid by the individual owners of the partnership, whereas at the C corp., the company is paying taxes at the corporate level. And then there is also the so-called double taxation of dividends issue in that when dividends are paid, those are also taxed.

Glaser: It's certainly a bit of an unusual structure. What kind of businesses can organize themselves as MLPs? Is there anything about the structures of those businesses that makes them more or less attractive to investors?

Larson: Well, these are attractive not only because they have a high yield, but because of the types of companies that are allowed to form under the MLP structure, which is basically midstream energy, these tend to be relatively attractive companies. Pipeline companies tend to have wide moats or in worst case narrow moats.

So, we have a relatively high proportion of high-quality companies that are formed under the MLP structures. Again, it's not just the yield that that should attract people. It is again the relatively stable nature and the wide moats that we find here.

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Glaser: But there are some complications, as you've talked about before, particularly when it comes to taxes. What should most investors know? It doesn't make sense to hold these in a tax-deferred account.

Larson: While they are attractive investments, there are these tax complications. And a couple of years ago, I would start going into these tax complications when I would be talking with investors. People's eyes they kind of glaze over, and they would say "Well, that's way too complex for me. I just don't want to deal with that."

But for those of us, who did want to deal with that, we've had some nice returns in recent years, and I still think there are returns. The main rule to keep in mind with these MLPs is that they are primarily suited for taxable accounts, and they generally should not be purchased in qualified accounts, such as IRAs or 401(k)s. The reason for that is that if you generate over $1,000 in income from these MLPs in that qualified account, that qualified account could have a tax liability, and that's just a tax headache that no one should want to have.

Also these MLPs also have some tax advantages that you want to be able to take advantage of. Because these investments have a distribution that is generally much larger than the actual taxable income that they generate, you have a portion of the distribution that is basically tax-free in the year that it's generated, and that portion of the taxes is being deferred. So, you have a tax deferral, and you're not going to have that recapture until you sell the shares. And if you don't sell the shares, you can put off that tax liability for a long period of time.

And as we all know, a dollar today is worth far more than a dollar in the future. Also if you happen to die owning these MLPs, your heirs actually get a stepped-up basis, and that tax on the distribution could in theory never occur.

Glaser: Well, it certainly sounds like it's worth bearing some of these complications in order to get access to these companies.

Larson: I think it is. I mean there is no doubt that there is a little bit more work that you have to do come tax-filing time. Instead of 1099, you're going to get a K-1, a little bit more complicated tax forms that you have to fill out. But again, if you're willing to jump through those hoops, the benefit that you get from investing here is a quite handsome.

Glaser: Paul, thanks for the advice.

Larson: Thanks for having me.

Glaser: For Morningstar, I am Jeremy Glaser.