Master Limited Partnership or MLP is one of my favorite investments to replace bonds. Obviously, nothing is “safer” than bonds, but the deceiving safety is really a wealth erosion in disguise (through inflation).
So what is MLP? MLPs are limited partnerships, but trades like all other stocks. Due to its partnership structure, an MLP usually doesn’t pay income taxes. The holders of partnership usually will get regular cash distribution out of partnership, almost like a dividend payment, except that you don’t pay any dividend taxes on it. The yields on MLP usually range from 6% to 9%, and the cash distribution grows about 5% annually, which is higher than utilities companies. Over the past ten years, MLPs have delivered above-average returns of 16.1% versus S&P 500 return of 9.9%. Not only that, MLP stocks are less volatile, and allows investors to participate in the energy sector with much lower risk.
The biggest hurdle for individual investors is the complexity of filing taxes on schedule K-1 which comes with these MLPs. The forms involved are schedule B, E, Form 8271 Investor Reporting of Tax Shelter Registration Number, etc. I used TurboTax to help me fill in all kinds of weird numbers in various forms, but as far as I know, Turbo Tax (2004 version) has a bug in calculating your accumulated capital gain/loss when you sell. You will end up paying a lot more taxes because it doesn’t account for box 1 in schedule K-1. I have emailed TurboTax 4 times, and called them 1 time, and I have basically given up on TurboTax. What normally happens in schedule K-1 (if you don’t sell) is that you only pay taxes on tiny amounts of interest & dividends from the MLP, but nothing on the cash distribution which is really the real MLP yield. At that time of sale, you will adjust your basis with all accounted interest/dividends and cash distribution, and all the gain will become a capital gain. If it’s long term, it can be taxed at the lower rate (even after dividend tax cut is repealed). And you can always choose not to sell until death, in which case, you will have a totally tax-free cash distribution for life, with cost-basis stepped-up at death for your heirs without incurring any capital gain taxes. That is (close to) zero tax for you & your heirs, with current income.
I have invested in more than 5 MLPs in the past, and the returns are terrific. The best ones are GTM which got bought out by EPD, and KPP which got bought out by VLI. I have sold out most of my MLPs, except MMP which has one of the higher growth rate in cash distribution. My primary reason of selling out MLPs is because of the rising yield of 10-year treasury bond which is competing very closely to MLP yields now. However, to my surprises, MLPs mostly have not gone down much. It appears that many other positive factors are working for MLPs (as described in my links at the bottom), all resulting in shrinking of the spread of yield premium over treasury bonds.
Here are the two best (and free) articles from Wachovia Securities on MLP. If you consider investing in MLP, you should definitely read those 40+ pages in the 2nd Edition. Not a single page will waste your time.
By the way, if you invest MLP in an IRA account, there is a UBTI (Unrelated Business Taxable Income) limit of $1000. Just be mindful of not hitting that limit.