Mastering Energy MLPs

Transcription

1 Mastering Energy MLPs pans and shovels. In the energy industry, the steadiest and most reliable earnings go not to the companies that bring the oil and gas from deep within the earth to the wellhead, but to the pipeline operators that get that oil and gas where it needs to go. by Josh Peters, CFA Editor, Morningstar DividendInvestor Ever since launching Morningstar DividendInvestor in early 2005, I ve been pining for a top-shelf selection in the utility sector. Utilities are known far and wide for large and steady dividend payments throughout a variety of economic circumstances, and their history of high payout ratios has made them a favorite of income-oriented investors for the better part of a century. Sadly, I have yet to find one utility stock that meets DividendInvestor s criteria for income safety, growth and total return. The trouble is twofold: not only is the utility industry not quite as steady as you might think, but utility stocks indicated returns in the past few years current yields around 4% plus long-term sustainable rates of dividend growth of 3%-5% at best are pitifully low. But what if there were an investment that could combine the predictable underlying earning power of a traditional utility with both higher current yields and faster growth? Look no further than pipeline MLPs (master limited partnerships). As you might expect, there is no free lunch MLPs carry certain tax characteristics that keep most investors from buying them and prevent many others from taking advantage of their hefty total return potential. But for the investor willing to make certain tradeoffs related to taxes, MLPs can offer yields of 6% and up with long-term growth potential easily in excess of inflation and total returns in the low double digits. Introducing Energy MLPs With gasoline running $3 a gallon and up, you might figure the big money in the energy industry is being made by oil and gas producers, refiners and marketers and you d be right. Some of the biggest gains in the California gold rush were indeed made by the miners who struck gold. But the steadiest, most reliable profits went to those who sold pickaxes, Consider Buckeye Partners BPL for example. One of the nation s largest carriers of refined petroleum products, it operates a pipeline network from the ports of New York and Philadelphia westward to Illinois and Missouri as well as other odds and ends. The value of the gasoline, diesel fuel, jet fuel and other commodities it carries can and will fluctuate wildly, but Buckeye doesn t participate in this volatility: it simply gets paid for carrying the liquids. Assets like these are every bit as necessary to the nation s energy infrastructure as your local electricity grid or natural gas hookup, and the cash flows that pipelines like Buckeye s generate are more-or-less as steady as those of the utility industry. The key differences are regulation and taxes. The rules that regulate pipelines are at least as favorable as those governing utilities (often more favorable, in fact); the tax picture is more complicated. Certain types of businesses in natural-resource and real-estate related fields are able to structure themselves as MLPs and avoid paying federal income taxes as the business level. However, the IRS naturally wants to tax the profits an MLP earns somewhere and that somewhere is at the investor level. Before tackling this subject head-on, I should note that Morningstar doesn t provide tax advice so I strongly suggest you consult a tax advisor to evaluate your personal investment and tax circumstances before investing in an MLP. I can, however, describe the basic mechanics of how MLPs work from a tax perspective, and I'm happy to share this information with you. Partnership Basics Unlike corporations, partnerships are not considered to be separate entities from their owners, but rather a contractual pooling of assets. Limited unitholders still have limited liability, though there is a theoretical Morningstar DividendInvestor Special Report 1

2 risk that creditors could go after cash distributions made as the result of management fraud. But from a legal and tax perspective, the partnership acts in your name rather than its own. The benefit of this form of business organization is that the partnership does not pay taxes itself. Instead, a partnership s taxable income (or loss) is divvied up among the partners and added to their individual tax returns. Each unitholder receives a Schedule K-1, a form that contains the proportional revenue, expenses, and profits attributable to his or her ownership. The key to understanding MLP taxation is this: Taxable income and cash distributions are completely separate concepts. Unlike REITs, which are obliged to pay out at least 90% of their taxable income so the government can tax shareholder dividends, a partnership s distributions and taxable income are related only in the sense that a profitable partnership is also likely to pay large cash distributions. This may not be quite an intuitive phenomenon, but it can offer a significant advantage for MLP investors. Partnership Taxes Illustrated To illustrate how MLP investments are taxed, let s consider a hypothetical investment in Buckeye Partners during Just before the close of trading on Dec. 29, 2005, I bought 100 units of Buckeye at $41.92 apiece a total investment of $4,192. Over the next twelve months, I received $ worth of cash distributions on my investment ($3.025 per unit). That made for a yield on my initial cost of 7.2% not bad, not bad at all. How much tax will I owe on these cash distributions in 2006? Technically speaking, zero 100% of MLP cash distributions are characterized as returns of capital. Returns of capital are a tax accounting concept that, rather than triggering taxable income, reduces the cost basis of the investment more on this in a bit. However, I will still owe tax: not on the cash distributions themselves, but on my pro-rata share of Buckeye Partners taxable income. The company will tell me what this allocation is on my Schedule K-1, and I ll have to include this information on my 2006 tax return. In March 2006, Buckeye s management estimated that that newly purchased units could expect allocations of taxable income equal to roughly 30% of cash distributions through the end of Assuming this relationship holds for 2006, I ll be allocated taxable income of $90.75 for my proportional ownership in Buckeye at the end of the year. This income is not qualified for the maximum 15% federal tax rate on dividend income that common stocks are; instead, I ll have to pay tax based on whatever tax bracket I happen to be in. If I m in the 28% tax bracket, my Buckeye investment will result in a tax bill for $ Note how low my actual tax liability of $25.41 is in relation to the $ in cash distributions I received just 8.4%. Indeed, my effective tax rate is lower than the 15% maximum federal rate on qualified dividends. What a deal! With a story this good there has to be a catch, and indeed there is. Unlike an investment in most traditional common stocks, where the cost basis is fixed at the original outlay for the investment, the cost basis of an MLP investment changes with each cash distribution and allocation of taxable income. If my allocations of taxable income are less than the cash distributions I receive from Buckeye, my taxable cost basis will fall. And if my cost basis is falling, that will enlarge the taxable income (or reduce any taxable loss) I will have to report when I eventually sell. Between my purchase on Dec. 29, 2005 and the end of 2006, here is how my cost basis changed: Buckeye Partners: Change in Cost Basis Taxable Cost Basis ( ) $4, Less: Cash Distributions: Plus: Allocation of Taxable Income: Taxable Cost Basis, : $3, Mastering Energy MLPs

3 Now let s say that I decide to bail out of Buckeye at the end of I sell my 100 units on Dec. 29, 2006 at $46.48 a unit, having held them just long enough to qualify for the long-term capital gains rate on my investment. I ve made out quite well: a total return in one year of 18.1% before taxes. Buckeye Partners: Tax Liability for 2006 Amount ($) Tax Rate (%) Tax Owed ($) Allocation of Taxable Income Recapture of Depreciation Capital Gains Totals: Buckeye Partners: Pretax Total Return Sale Proceeds on $4, Cash Distributions Received (7.2%) Less: Original Cost on , Total Return: $ (18.1%) If Buckeye Partners had been an ordinary corporation, the taxes would be fairly simple. I d owe income tax on my $ worth of cash distributions and capital gains tax on the $456 of my total return that represented capital appreciation. The federal tax rates on both would be a maximum of 15%, I d give up no more than $ of my return to the IRS. However, with MLPs the math is not nearly so simple. There are three moving parts to consider: First, Buckeye allocated $90.75 worth of taxable income to me in Being in the 28% tax bracket, I will owe $25.41 in tax on this portion of my total return. Second, there s my capital gain. I originally paid $4,192 for my Buckeye units, and I sold them for $4,648. I ll owe capital gains tax of 15% on this $456 profit, or $ Finally, there is a third form of income that arises from the difference between my actual purchase price of $4,192 and my taxable cost basis. Between cash distributions (which reduced my cost basis) and allocations of taxable income (which increased it), my cost basis fell by $ during 2006 to $3, The IRS treats this reduction as a recapture of past depreciation deductions taxable not at the capital gains rate, but as ordinary income. I ll owe tax on this income at my ordinary income tax rate of 28% for a tax liability of $ In the end, I wound up paying a blended tax rate of 20.2% on my total return higher than the 15% maximum rates for both qualified dividends and longterm capital gains. Because depreciation accounts for the bulk of the difference between taxable income and cash distributions, we may as well assume that 100% of the cash distributions paid by an MLP will be taxed at ordinary income tax rates-if not all today, then eventually. The key tax benefit of owning an MLP isn t in the average tax rate payable during the life of the investment-which, as with REITs, will be higher than the rate assessed on ordinary common stocks-but on the ability to defer taxable income until units are sold. If I buy and hold a well-managed MLP indefinitely, I can put off a good portion of the tax indefinitely as well. Thankfully, MLPs maintain comprehensive tax basis information for their investors. Since I sold my Buckeye units hypothetically speaking, that is the amounts of income taxable as ordinary income and capital gains will be reported separately on my Schedule K-1. Four more points merit brief mention: Depending on what a partnership is up to in a given year, its taxable income can include qualified income (dividends from taxable corporate subsidiaries) or capital gains taxed at rates lower than ordinary income. Whatever the composition of the partnership s income, it will be listed on the Schedule K-1. If I held Buckeye long enough, my cost basis could fall to zero. At that point, I ll have to pay tax on 100% of my cash distributions regardless of the taxable income-and at full ordinary income tax rates at that. Looking at Buckeye today, however, this situation is decades away. Morningstar DividendInvestor Special Report 3

4 Should an MLP report a taxable loss to its unitholders which is not unusual given how large depreciation deductions and other tax breaks typically are that loss can t be used to offset other income in that year it can only be used to shield future income from the same MLP. The most relevant long-term concern relates to the taxable income of Buckeye itself. When I purchase units, Buckeye establishes a set of tax accounting books for my individual investment. If I pay a premium to the partnership s book value (as I did), Buckeye writes the value of its property up to the price I actually paid and starts depreciating this much higher cost. This explains why my allocation of taxable income is so much smaller than the net profit Buckeye reports for accounting purposes. Over time, however, the ratio of my taxable income to the cash distributions I receive is likely to rise. All else being equal, I d probably owe a higher proportion of my income in tax for 2007 than I did in 2006, still more in 2008, and so on. But Buckeye s steady distribution growth, as well as the depreciation deduction for new assets it puts in service, should keep my after-tax income on the rise. Tax Filing As I mentioned earlier, the taxable income of a partnership is reported to unitholders on a Schedule K-1. The investor must include the K-1 s information on his or her tax return. With those figures consolidated in the investor s taxable income, the government finally gets to tax the partnership s bottom line. Fortunately, software programs like TurboTax to say nothing of professional tax preparers are well equipped to handle the paperwork. However, the federal government isn t the only party interested in a partnership s taxable income. State governments also want to tax these earnings. As with the federal K-1, a partnership passes on the taxable income attributable to its profits in individual states. This is where the worst element of complexity can come in. Kinder Morgan Energy Partners KMP, for example, does business in 40 states. If Kinder Morgan earns taxable profits in each of those states, and your share of these slivers of income was high enough to require filing, you might have to file tax returns as a nonresident and pay taxes in all of those states. However, if filing in multiple nonresident states is the biggest potential headache related to MLPs, an individual unitholder is unlikely to have enough income to require filing in many, if not all, of these jurisdictions. State revenue authorities generally have minimum thresholds for taxable income or the tax itself before requiring taxpayers to file. For example, a partnership stake worth $20,000 might throw off $1,200 in annual distributions but just $400 in taxable income. That in turn might be divided by 20 or more states and fail to hit the minimum income or tax threshold in any one state. But individual states requirements-as well as the taxable income attributable by any particular partnership to any one state-will vary widely, and for a large investment would be worth investigating in advance. MLPs and Tax-Deferred Accounts The most common question I ve received lately is, Can I own MLPs in an IRA? The technical answer is yes, but be ready for complications. The Internal Revenue Service does not specifically prohibit tax-deferred accounts like IRAs, 401(k)s, Keoghs, and the like from holding partnerships. Instead, tax-exempt entities (including tax-deferred retirement accounts) are limited to $1,000 in what it calls unrelated business taxable income. This limit applies to the total income received by all partnerships in a single account, not just any one position. (However, it doesn t apply to the taxpayer as a whole-each IRA you might have has its own $1,000 limit.) If a particular account jumps the $1,000 limit, the account itself (not the taxpayer) will have to file a tax return (Form 990-T) and pay tax at corporate rates. Filing a 990-T and paying taxes would be a big drag not least because the income stands to be taxed again when withdrawals are made. 4 Mastering Energy MLPs

5 2007 Morningstar, Inc. All rights reserved. Any opinions, recommendations, or information contained herein: (i) are for educational purposes only; (ii) are not guaranteed to be accurate, complete, or timely; (iii) have not been tailored to suit any particular person s portfolio or holdings; and (iv) should not be construed as investment advice of any kind. Neither Morningstar nor any of its agents shall have any liability with respect to such opinions, recommendations, or information. Morningstar has not given its consent to be deemed an expert under the federal Securities Act of Past performance is no guarantee of future results. Before making any investment, consult with your financial advisor. Morningstar employees may have holdings in the stocks recommended. Getting Paid for Paperwork Thus far, I ve mostly been describing the bad news the paperwork stands to be something of a headache, and paperwork does cost money (especially if you re paying someone else to do your taxes). The good news is that MLPs offer some of the best cash yields in the market today, along with above-average prospects for growth and total return. Let s say I had a choice between a utility with a 4% yield and an MLP paying 7%. We ll further assume that both income streams can grow at 4% annually more or less par for both sectors. If I had $1,000 to invest, the MLP would provide an extra $30 more of annual pretax income than the utility, but it might cost that much or more to process the MLP paperwork. I d probably be better off with the utility. But if I was considering a $10,000 investment, with a difference in income totaling $300 a year, the extra income and total return should be enough to offset any extra filing costs. Limited Partners and General Partners Every MLP has at least one general partner, which manages and (for all practical purposes) controls the partnership. Although the general partner s ownership stake in the partnership is usually very small (2% or less is typical), most MLPs provide incentive distributions to general partners that are linked to the payments to limited unitholders. As the per-unit distributions to limited unitholders rise, the general partner stands to collect a rising share of the total amount of cash distributed. Buckeye GP Holdings BGH, for example, is entitled to 31% of any increase in the distributions Buckeye Partners pays out. New issues of units at the limited partnership level also stand to boost the cash paid to the general partner, because there will be that much more total cash distributed. The year 2006 saw a boomlet in general partner initial public offerings, Buckeye GP among them. Also organized as partnerships, these entities may contain nothing more than the incentive distribution rights of the underlying partnership. As a result, their perunit distributions stand to grow much more quickly. I estimate that 4% distribution growth for Buckeye Partners translates to at least 8% for Buckeye GP. Indeed, in August 2007, Buckeye GP s quarterly cash distribution increase of 4.2% was more than double Buckeye Partners 1.6% hike. On the other hand, these GP entities are somewhat riskier than the partnerships from which they derive their value, since any reduction in limited unitholder distributions tends to hit the general partner s take twice as hard. Faster growth means that their yields tend to be lower than the underlying partnerships. Bottom Line Well-informed and well-advised investors need not fear MLPs. The total returns offered by pipeline partnerships fall in a range of 10%-14%, compared to just 6%-8% available from traditional utility corporations. With a combination of paperwork and homework, we can earn attractive total returns-even after considering the tax implications. œ Morningstar DividendInvestor Special Report 5

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