Protect Your MLP Profits From The Tax Man -- Here's How

StreetAuthority Network

Over the past decade, we've spent a considerable amount of time researching master limited partnerships (MLPs). They've emerged as a popular way to benefit from our nation's rapidly growing energy infrastructure. Most MLPs are focused on the energy sector, though some are involved in real estate and other entities (such as pro basketball's Boston Celtics).

MLPs have soared in popularity as they've delivered stellar returns. According to the National Association of Publicly Traded Partnerships, the Alerian MLP Index (a proxy for almost all publicly traded energy MLPs) delivered a 16.5% annualized gain in the 10 years ended December 2012. That beat the annualized gains of commodities (10.6%), small cap stocks (9.7%), the S&P 500 (7.1%) and hedge funds (6.8%).

Many of our favorite MLPs continue to possess robust growth prospects in the years ahead as well, thanks to industry plans to dig for more oil and gas and to build more pipelines to transport these energy sources.

The appeal of these MLPs is self-evident: They offer juicy dividend yields and are structured to avoid paying income taxes. That second factor can also be seen as a clear negative: Since they don't pay taxes on their profits, you do. And depending on what type of MLP investment we are talking about, the tax bite can come at precisely the wrong time. As you shift your portfolio to minimize the tax bite for next year, it pays to take a closer look at the tax implications for various MLP investments now.

Deferred, Not Avoided
Many MLPs issue a year-end tax form, known as a K-1. You don't need to pay any taxes when the tax bill comes, as long as you continue to own that MLP. But keep track of those forms, as you will owe taxes on all of the accrued gains from the MLP's investments once you do decide to sell. That's why it pays to sell an MLP in a year when your total tax bill is under control.

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Notably, you can't use any profits or losses from a K-1 to offset gains or losses on any stocks that show up on your Form 1099. The fact that the K-1 also often needs to be filed with your state as well can create a lot of tax headaches, leading many to seek out the guidance of a tax preparer.

And don't think you can simply avoid taxes by parking an MLP in a retirement account. MLPs typically generate what's known as "unrelated business taxable income," and if the income exceeds $1,000, then the IRS insists that you break out that income on your returns.

Exchange-traded funds (ETFs) and mutual funds that own MLPs create another set of headaches: Taxes that are owed are subtracted from these funds' net asset value (NAV), making for a tricky calculation when it comes time to determine your tax basis.

I-Units: A Better Alternative
In response to the tax complexities of MLPs, some firms have created parallel tracking stocks that sidestep the Schedule K-1 or deferred tax issues. Known as i-units, these vehicles return profits to investors in the form of newly issued shares, which doesn't trigger a taxable event every year. You'll still owe taxes when you finally sell, unless you hold them in a retirement account, but at least there aren't a series of K-1 forms you need to track. Simply put, holding these i-units in a retirement account is the most tax-savvy approach for a tax-messy asset class.

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Right now, there are only a few options, including:

Kinder Morgan Management (NYSE: KMR), which currently sports a 7.2% yield (payable in shares).
Enbridge Energy Management (NYSE: EEQ), which issued 1.86 new shares for every 100 shares held in November, which works out to be a 7.4% yield on an annualized basis.

Of course, tax strategies shouldn't dictate which MLP is best for you. Both Kinder Morgan and Enbridge Energy have proven track records -- but other smaller MLPs may have greater growth prospects. (Last week, my colleague Joseph Hogue examined what makes Kinder Morgan especially attractive.)

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The Alerian MLP ETF (NYSE: AMLP) is another investment vehicle that aims to avoid tax headaches. This fund owns MLPs but is structured like a typical corporation investment, meaning you'll simply see its returns on a Form 1099, not a K-1. Yet as Morningstar notes, "the fund is liable for taxes at the corporate level, which has caused AMLP to lag its underlying index by a staggering 7.5% annualized since inception through the end of November." They add that the fund is "most appropriate for risk-averse investors willing to give up capital appreciation in exchange for preserving the tax-advantaged yield offered by MLPs."

Risks to Consider: MLPs are sought out by yield-hungry investors, and an environment of rising rates in 2014 may lead more investors to fixed-income investments and away from income-producing equities.

Action to Take --> Tax forms will be arriving in the mail shortly, which makes this a good time to study the tax implications of any MLPs you currently own. You can reduce your future tax bite by adjusting the kinds of MLPs you own. Also look for other MLP issuers to follow the path of Kinder Morgan and Enbridge Energy in 2014, producing i-unit vehicles of their own.

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