Master Limited Partnerships 101:

Master Limited Partnerships 101: Presentation to the American Association of Individual Investors Silicon Valley Chapter April 16, 2011 2010 National Association of Publicly Traded Partnerships 1

Master Limited Partnerships 101 I. What is an MLP and why should I care? II. III. IV. History of MLPs MLPs Today How MLPs Work V. Investing in MLPs VI. For more information 2011 National Association of Publicly Traded Partnerships 2

Master Limited Partnerships 101 What is a Master Limited Partnership? (MLP) 2011 National Association of Publicly Traded Partnerships 3

Master Limited Partnerships 101 A more accurate term, and the one used in the tax code, is publicly traded partnership. Simply, it is a partnership, or an LLC that has chosen partnership taxation, that trades on a public exchange (NYSE, NASDAQ, AMEX) or over the counter market. 2011 National Association of Publicly Traded Partnerships 4

Master Limited Partnerships 101 Are master limited partnerships (MLPs) and publicly traded partnerships (PTPs) the same thing? 2011 National Association of Publicly Traded Partnerships 5

Master Limited Partnerships 101 Simple answer: For most purposes, yes. The two terms are used interchangeably. Technical answer: Technically, no. An MLP is a partnership with a certain structure, not necessarily publicly traded (though most are). And some PTPs are not MLPs, but publicly traded limited liability companies (LLCs) taxed as partnerships. 2011 National Association of Publicly Traded Partnerships 6

Master Limited Partnerships 101 Why should I know about Master Limited Partnerships? 2011 National Association of Publicly Traded Partnerships 7

Master Limited Partnerships 101 The two biggest reasons: Income: Many investors are seeking investments that pay income regardless of share price fluctuations Tax Advantages: Because MLPs are partnerships, investors get more of the income and pay less tax on it. 2011 National Association of Publicly Traded Partnerships 8

Master Limited Partnerships 101 History of MLPs Master limited partnerships have been around for almost three decades 2011 National Association of Publicly Traded Partnerships 9

History of MLPs The first MLP was launched in 1981: Apache Oil Company. Its purpose was to raise capital from smaller investors by offering them a partnership investment in an affordable and liquid security. Other oil and gas MLPs soon followed and were joined by real estate MLPs. 2011 National Association of Publicly Traded Partnerships 10

History of MLPs Rapid Growth in the 1980s MLPs multiplied and began to be used in other industries: hotels and motels, restaurants, cable TV, investment advisors, even amusement parks and the Boston Celtics. Congress and tax officials worried about disincorporation --i.e., that large numbers of corporations would become MLPs to avoid corporate tax. 2011 National Association of Publicly Traded Partnerships 11

History of MLPs In 1987 Congress passed legislation to define and limit publicly traded partnerships It created Section 7704 of the Tax Code, limiting partnership tax treatment to PTPs earning >90 percent of their income from specific sources. Existing PTPs with bad income were grandfathered. Most gradually went private, were acquired or converted to other structures; only three remain today. 2011 National Association of Publicly Traded Partnerships 12

History of MLPs What kinds of income can a PTP earn? Interest, dividends, and capital gains Rental income and capital gains from real estate Income and capital gains from natural resources activities Income from commodity investments Capital gains from sale of assets used to generate the above types of income 2011 National Association of Publicly Traded Partnerships 13

History of MLPs Qualifying Natural Resources include: Oil, gas, petroleum products Coal and other minerals Timber Any other resource that is depletable under section 613 of the federal tax code Industrial source carbon dioxide (added in 2008) Ethanol, biodiesel, and other alternative fuelstransportation and storage only (added in 2008) 2011 National Association of Publicly Traded Partnerships 14

History of MLPs Qualifying Natural Resource Activities include: Exploration, development & production (E&P) Mining Gathering and processing Refining Compression Transportation (pipeline, ship, truck) Storage, marketing, distribution But not retail sales (no gas stations) 2011 National Association of Publicly Traded Partnerships 15

History of MLPs During the late 1980s and the 1990s: Many of the original oil and gas MLPs left the market, unable to maintain distributions as oil and gas prices dropped. Many of the original real estate MLPs disappeared during the real estate slump or converted to REITs. Integrated energy companies began selling or spinning off midstream assets (gathering, processing, pipelines, distribution) to MLPs to pursue more profitable investments. 2011 National Association of Publicly Traded Partnerships 16

History of MLPs During the 2000s: The number of MLPs in oil and natural gas midstream businesses steadily increased. They were joined by MLPs engaged in marine transportation of petroleum products and in propane distribution. Some MLPs were formed in the coal industry Beginning in 2006 exploration and production MLPs began to make a comeback. 2011 National Association of Publicly Traded Partnerships 17

History of MLPs Several general partners of MLPs went public as MLPs themselves in 2005 and 2006 but now several have recently been folded back into the original MLP. Several investment managers turned their holding companies into PTPs (e.g., Blackstone) but Congress may stop investment managers from doing this in the future. 2011 National Association of Publicly Traded Partnerships 18

Master Limited Partnerships 101 Master Limited Partnerships Today 2011 National Association of Publicly Traded Partnerships 19

MLPs Today Roughly 90 MLPs are actively trading (exact count is hard to get). Today s MLPs primarily focus on energy-related industries and natural resources. Most are in oil and gas midstream industries; others are in other oil and gas activities and coal. A few remain in real estate; most of the rest are in investment/financial activities. 2011 National Association of Publicly Traded Partnerships 20

MLPs Today: Changes in Industry Groups MLPs by Industry Group-1990 Other 32% Energy and Natural Resources 37% Real Estate (incl. mortgage securities) 31% 2011 National Association of Publicly Traded Partnerships 21

MLPs Today: Changes in Industry Groups MLPs by Industry Group Today Energy and Natural Resources 77% Other Businesses 4% Investment 11% Real Estate (incl. mort. sec.) 8% 2011 National Association of Publicly Traded Partnerships 22

MLPs Today: Changes in Industry MLPs by Industry - 1990 Investment/ Financial 5% Other Businesses 15% Oil and Gas Exploration & Production 21% Hotel, Motel, Restaurant 12% Oil and Gas Midstream 10% Real estate-mortgage securities 13% Real Estate- Developers, Homebuilders 4% Real estate-income properties 14% Oil and Gas Marine Transportation 1% Minerals and Timber 5% 2011 National Association of Publicly Traded Partnerships 23

MLPs Today: Changes in Industry Master Limited Partnerships by Industry - 2011 Other Businesses 4% Oil and Gas Midstream 43% Investment/Financial 11% Real Estate - Mortgage Securities 4% Real Estate Properties 3% Other Minerals, Timber 2% Oil & Gas E&P 12% Coal Marine Transportation 7% Propane & Refined Fuel 2011 National Association of Publicly Traded Partnerships 7% 24 7%

MLPs Today: Market Capital Total MLP market capital today is around $283 billion About 87 percent of the total, about $245 billion, is attributable to energy and natural resource MLPs. 2011 National Association of Publicly Traded Partnerships 25

MLPs Today: Market Capital PTP Market Capital - by Industry Group Energy and Natural Resources 87% Other 1.5% Investment/ Financial 11% Real Estate 0.6% Market Capital on 4/7/11 2011 National Association of Publicly Traded Partnerships 26

MLPs Today: Market Capital Oil & Gas E&P 6% Investment/ Financial 11% Other 1.5% Real Estate- 0.6% Other Minerals, Timber 0.8% Coal 4% Propane & Refined Fuel 4% Marine Transportation 2% Market Capital by Industry Oil and Gas Midstream Operations 70% 2011 National Association of Publicly Traded Partnerships Market Capital on 4/7/11 27

Master Limited Partnerships 101 HOW MLPs WORK 2011 National Association of Publicly Traded Partnerships 28

How MLPs Work MLPs that are limited partnerships have: One or More General Partners (GPs) GP Manages Partnership Generally has ~2% ownership stake in partnership May have incentive distribution rights (IDRs) Thousands of Limited Partners (LPs)/Unitholders Unitholders = LPs holding publicly traded units Provide capital Have no role in partnership s operations or management Receive quarterly cash distributions 2011 National Association of Publicly Traded Partnerships 29

How MLPs Work Typical Limited Partnership Structure Corporate Parent or Other Owners Pipeline GP LLC General Partner (2%) 2% GP LP Interest Interest LP Interest Unitholders- Limited Partners Pipeline MLP, L.P. 100% Owned Pipeline Operating LLC (or L.P.) Operating Subsidiaries 2011 National Association of Publicly Traded Partnerships 30

How PTPs Work MLP With Publicly Traded GP Corporate Parent or Other Owners LP Interest Pipeline GP Holdings, L.P. 100% Membership Interest Pipeline GP LLC General Partner <2% GP Interest Public Unitholders- Limited Partners Public Pipeline GP Unitholders- Holdings, L.P. Limited Partners Pipeline MLP, L.P. Pipeline Operating LLC (or L.P.) Operating Subsidiaries 2011 National Association of Publicly Traded Partnerships 31

MLPs That Are LLCs: Have members rather than partners thousands of public unitholders own membership interests rather than LP interests Have no GP. Management owns same membership interests as unitholders Have no IDRs How MLPs Work LLCs All members, including public unitholders, have voting rights 2011 National Association of Publicly Traded Partnerships 32

How MLPs Work Typical LLC Structure Management Public Unitholders (Members) Other Owners (Members) Energy Co., LLC Operating Subsidiaries 2011 National Association of Publicly Traded Partnerships 33

How MLPs Work In both Limited Partnerships and LLCs: Lower-level entities, not the MLP, own the assets and conduct operations Taxation is on a pass-through basis There is no corporate or other entity-level tax All tax items flow through to the LPs or members, who pay tax at their own rates 2011 National Association of Publicly Traded Partnerships 34

How MLPs Work Characteristic MLP LLC Corporation Taxable at entity level No No Yes Tax Items Flow Through Tax Deferral on Distributions Yes Yes No Yes Yes No Tax Reporting K-1 K-1 DIV-1099 General Partner Yes No No IDRs Yes No No Investor Voting Rights No Yes Yes 2011 National Association of Publicly Traded Partnerships 35

How MLPs Work Why Companies Choose MLP Structure Pass-through tax structure (no double taxation) means lower cost of capital, providing advantage in acquiring and maintaining assets Can own rate-regulated assets and still give investors an attractive rate of return Public trading allows MLP to raise funds from broader range of investors than non-traded partnership Operating as an MLP rather than a corporation gives management greater control 2011 National Association of Publicly Traded Partnerships 36

Master Limited Partnerships 101 Investing in MLPs 2011 National Association of Publicly Traded Partnerships 37

Investing in MLPs Being an MLP unitholder is different from being a corporate stockholder: Taxation of your investment is very different and usually more favorable Depending on the structure, you may not have voting rights (LPs generally don t, though some MLPs allow LPs to vote for some Board members; LLC members do) 2011 National Association of Publicly Traded Partnerships 38

Investing in MLPs Taxation Partnership Tax Basics: Income An MLP is a pass-though entity which pays no tax itself. The unitholder is treated for tax purposes as if he is directly earning the MLP s income. Each unitholder is allocated on paper a share of the MLP s income, gain, deductions, losses, and credits. This is reported annually on the K-1. The unitholder calculates his share of taxable income and pays tax on it at his own tax rate. 2011 National Association of Publicly Traded Partnerships 39

Amount per share / unit: Corporation MLP Gross Income $4.00 $4.00 Deductions (depreciation, etc.) -$3.00 -$3.00 Taxable Income $1.00 $1.00 Federal corporate tax -$0.35 $0.00 State tax (assumes 5% rate) -$0.05 $0.00 Entity's net income $0.60 $1.00 Shareholder's federal tax (28%) Investing in MLPs Taxation Example -$0.17 -$0.28 Shareholder's state tax (5%) -$0.03 -$0.05 Net income to shareholder $0.40 $0.67 2011 National Association of Publicly Traded Partnerships 40

Tax Basics: Distributions You will receive quarterly cash distributions, which are no the same as your taxable share of the MLP s income. Distributions are based on distributable cash flow (DCF), which is: Net earnings, plus Investing in MLPs Taxation Depreciation (which is subtracted from income in the earnings calculation but is not a cash expense), minus Amounts needed for maintainance and repair of assets used in producing income 2011 National Association of Publicly Traded Partnerships 41

Investing in MLPs Taxation Tax Basics: Distributions Under the tax code, the distributions are a return of capital and are not taxed when received. Your basis in your partnership units (the amount you paid + or - adjustments) is lowered by the amount of the distribution. Thus, when you sell your units, your taxable gain (sales price minus adjusted basis) is increased by the amount of the distributions. 2011 National Association of Publicly Traded Partnerships 42

Investing in MLPs Taxation Often you will hear someone say that 80% of the MLP s distribution is taxdeferred. What they really mean is that the unitholder s allocated share of taxable income as reported on the K-1 ($.50 per unit in the example) equals only 20% of the distribution. 2011 National Association of Publicly Traded Partnerships 43

Corporations - Dividends Corporation pays tax on earnings After-tax earnings paid to shareholder as dividend Shareholder pays tax on dividend Partnerships - Distributions Investing in MLPs Taxation Partnership does not pay tax; income and deductions flow through to partners Partners pay tax on net earnings (regardless of cash received) Cash distribution treated as tax deferred return of capital 2011 National Association of Publicly Traded Partnerships 44

Investing in MLPs Taxation Basis Adjustments Your basis is adjusted not only by distributions but by tax items: Your share of partnership income each year adjusts the basis upwards. Your share of deductions like depreciation adjusts it downwards. The idea is that all income you receive from the partnership is taxed once and only once either in the year you receive it, or when you sell your units 2011 National Association of Publicly Traded Partnerships 45

Investing in MLPs -- Taxation Adjusted Basis Example Year 1: 1,000 units purchased @ $30.00. Basis is: Investor receives total cash distributions of $2.50/unit Investor is allocated and pays tax on net taxable income of $.50/unit $30,000 - $2,500 + $ 500 Adjusted Basis $28,000 Year 2: All units sold @ $32.00 $32,000 Gain per unit - $32.00 - $28.00 $ 4,000 2011 National Association of Publicly Traded Partnerships 46

Investing in MLPs Important Note: Taxation Not all of the gain when units are sold is taxed at capital gains rates. The gain resulting from basis reductions due to depreciation is taxed at ordinary income rates this is called recapture. Gain attributable to your share of some types of assets substantially appreciated inventory and unrealized receivables is also taxed as ordinary income. 2011 National Association of Publicly Traded Partnerships 47

Income: Investing in MLPs Advantages MLPs pay out earnings not needed for current operations and maintenance of capital assets to their unitholders in the form of quarterly cash distributions. Most MLPs strive to increase their distributions as often as is possible and prudent. Tax benefits: no double taxation, sheltering of income, tax deferral on distributions 2011 National Association of Publicly Traded Partnerships 48

Investing in MLPs Advantages Liquidity MLPs provide the tax benefits of partnerships without tying up your money for years. Estate planning: as with other securities, the basis in PTP units is stepped up to fair market value at death the heir receives a fresh start with no taxation of previous distributions 2011 National Association of Publicly Traded Partnerships 49

Investing in MLPs Challenges As we ve seen, tax reporting for an MLP investment is more complex than for shares in a corporation. Investor receives a K-1 instead of a 1099 The K-1 reports investor s share of all MLP tax items, which investor must enter on his/her own return MLPs make the process as easy as possible. Many post K-1s online, and they can be downloaded into Turbotax. 2011 National Association of Publicly Traded Partnerships 50

Investing in MLPs State tax issues: Challenges Partners may owe tax on their share of income allocable to each state in which PTP operates Practically, after PTP income is divided among all partners and all states, and depreciation and other deductions applied, a unitholder s income in each state will likely be too small for tax to be owed, except for those with large holdings. 2011 National Association of Publicly Traded Partnerships 51

Investing in MLPs Retirement Plans Think carefully before investing your IRA, 401(k), or other retirement plan in MLPs. These plans are tax-exempt already, so don t need the tax advantages. More importantly, the plan s share of net partnership income over $1,000 (not the distributions) is likely to be subject to unrelated business income tax (UBIT). 2011 National Association of Publicly Traded Partnerships 52

Investing in MLPs Retirement Plans UBIT is imposed on tax-exempt entities (including retirement plans) that earn income from a business that is not related to the purpose of their tax exemption. Because MLPs are pass-through entities, taxexempt partners (e.g., your IRA) are treated as directly earning the MLP s business income and are taxed on it. Investment income like interest, dividends, and royalties is not taxed. 2011 National Association of Publicly Traded Partnerships 53

Investing in MLPs Retirement Plans Some analysts feel MLPs are still a good investment for IRAs and other retirement funds, because: The tax is on net income. Passthrough of depreciation and other deductions means net income may be below $1,000. Even if tax is owed, the income may be sufficient to produce a very good return. If your IRA or 401(k) does owe UBIT, it, not you, owes the tax. The plan custodian should file a return and pay tax from the plan s funds. 2011 National Association of Publicly Traded Partnerships 54

Investing in MLPs Alternatives to Direct Investment I-Shares: Kinder Morgan and Enbridge Energy Partners have publicly traded management companies (KMR and EEQ) that issue I-shares. The companies only assets are the underlying MLPs, and distributions consist of additional i-shares. Because KMR and EEQ are in corporate form, there are no K-1 and no UBIT but also no distributions in cash. Investing Through Funds: Over the last few years, a number of options have been developed for investing in MLPs through mutual and other funds. 2011 National Association of Publicly Traded Partnerships 55

Investing in MLPs Alternatives to Direct Investment Closed-end mutual funds: There are a variety of closed-end funds focusing on MLPs. Tortoise Capital and Kayne Anderson are the leaders in this area; there are several others as well. Open-end mutual funds: New this year, SteelPath has a family of three MLP funds; and Swank Capital just added an open-end fund to its Cushing fund family. Exchange Traded Funds: Another recent development there are 4 MLP-focused ETNs and one ETF pegged to MLP indexes. 2011 National Association of Publicly Traded Partnerships 56

Investing in MLPs Alternatives to Direct Investment Advantages to investing through funds: A diverse MLP portfolio selected by experts. The fund is the limited partner; it rather than the investor deals with the K-1 form and paying federal and state taxes on partnership income. The investor receives a dividend and the familiar 1099 form. The dividend retains return of capital treatment to a large extent. The investment can be placed in a retirement account without generating UBIT. 2011 National Association of Publicly Traded Partnerships 57

Investing in MLPs Alternatives to Direct Investment Disadvantages to Investing Through Funds Reduced tax benefits: The funds are generally corporations and must tax on their share of K-1 income at the corporate rate before paying you. You will not get the benefit of any deduction or loss pass-throughs. Reduced return: In addition to taxes, your return will be diminished by administrative fees and expenses charged by the fund. Be sure to examine and compare these before investing. 2011 National Association of Publicly Traded Partnerships 58

Publicly Traded Partnerships 101 How can I find out more about MLPs? 2011 National Association of Publicly Traded Partnerships 59

Visit the NAPTP website www.naptp.org 2011 National Association of Publicly Traded Partnerships 60

Contact Information Mary Lyman Executive Director, NAPTP 1940 Duke Street, Suite 200 Alexandria, VA 22314 (703) 518-4185 mlyman@naptp.org 2011 National Association of Publicly Traded Partnerships 61