In early January, Paul Siers, a Raymond James adviser at Isabella Bank in Mount Pleasant, Mich., was hunting for some dividend-paying equities to help his clients eke out a little investment income in a horrendous market.
"While I found a few acceptable ones, the pickings were indeed slim," he said. "Then I found MLPs," or master limited partnerships, which at the time were paying cash distributions of 7%. Yields are currently in the 8%-15% range, Siers said. "That's what got me interested."
Master limited partnerships could reward Siers' clients — one recent offering posted a yield in the 24% range. Assuming interest rates rise over time, the principal value of master limited partnerships will fall. But Siers said these vehicles will remain interesting for at least the next two years as the economy recovers.
Siers, who manages assets of $78 million, produced $377,000 last year, as his business grew more than 30%. He has already added master limited partnerships to the fixed-income portfolios of 60 to 70 of his 1,000 clients. He said he and his clients are conservative, so he's proceeding cautiously.
Master limited partnerships were created by the Revenue Act of 1987 to help spur energy exploration and production in the Gulf of Mexico. There are currently some 100 master limited partnerships on the market. They don't have to pay corporate income taxes if 90% or more of their gross income is considered "qualifying," which, according to section 7704 of the tax code, is "income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil or similar products) or the marketing of any natural resource (including fertilizer, geothermal energy and timber)."
"Partners" are divided into two classes: general partners, the 2%-plus owners are on the hook for any legal matters; and limited partners, who provide capital and receive cash distributions, own common units instead of shares of stock. Because master limited partnerships don't pay corporate taxes, their distributions are higher than stock dividends, which are usually taxed both at the corporate and individual level.
Master limited partnership distributions are generally 75% to 95% tax-deferred until the unit is sold. As a result, yearly income tax applied to a master limited partnership distribution will be less than the tax on an equity dividend that offers a similar pretax yield, a Raymond James guide to master limited partnerships said.
Since more than 80% of the cash distribution from most new master limited partnerships are tax-deferred, only 20 cents on the dollar is taxable at the unit holder's ordinary income rate. Another tax advantage of master limited partnerships is that, like equities, they get a step-up in basis to the current market value at the death of the owner. This effectively eliminates any capital-gains liability for the heirs.
"In the past, I would never have even thought about these investments for a senior citizen," Siers said. "But given the estate-tax benefits, I feel it could be fitting in some situations and am discussing it with those clients."
The downside is that, like ordinary equities, master limited partnerships face the same industry risks that accompany any energy investment, and cash distributions can be reduced or eliminated at any time.
Master limited partnerships also may not be suitable for individual retirement accounts, because they can be subject to an "unrelated business" tax and complex tax filing, which applies even in an otherwise tax-deferred IRA.
Master limited partnerships aren't as straightforward as other investments when it comes to taxes, so it is important for advisers to school the certified public accountants they work with as fellow centers of influence, Siers said. "If CPAs don't understand how MLPs work and how they impact clients' tax returns, they won't support MLPs," he said.
A master limited partnership is pretty much the same as a stock purchase in terms of an adviser's production, Siers said, but it's not that simple for clients. That's why he doesn't recommend them to clients with otherwise-uncomplicated 1040 tax returns. For those whose tax returns are already complex enough to warrant CPA attention, the additional paperwork isn't too much of a headache, Siers said.
Another advantage of master limited partnerships is that although prices tanked along with everything else in this latest market meltdown, they generally aren't correlated with equities.
They therefore offer extra diversification that should make a portfolio more stable in normal markets. Add to that the obvious benefit of high cash distributions compared with more run-of-the-mill, fixed-income products and dividend-paying stocks, and Siers said advisers owe it to their clients to at least look at what master limited partnerships might accomplish as part of an investment portfolio.