Taxation of Master Limited Partnerships

Dividend Tree recently asked me about the distributions from Kinder Morgan Energy Partners (KMP) which is a Master Limited Parnership (MLP) . MLPs are not like regular corporations and do not get taxed on income. Instead they tend to return most of their income (typically 85 to 90%) to investors or partners through quarterly distributions. This shifts the tax responsibility to the partners, who are taxed at their ordinary income rates. Since ordinary income rates of investors are typically lower than the income tax rates of corporations, this proves to be advantageous to the MLPs and hence their investors. Here is a good article from Forbes by Joseph Tatusko talking about the stability, tax benifits and strong performance in a low interest rate environment of MLP's.

Income Pipelines
In times of heightened uncertainty and higher volatility, it's important to be reminded that not all markets or sectors misbehave or perform similarly when the going gets tough. Master limited partnerships (MLPs) have been an exception to the malaise in equities the first several weeks of 2008 and as a group appear very well positioned to benefit from lower interest rates.

MLPs don't always perform in the same manner as other traded equities because they differ in several key aspects. MLPs do not pay corporate income tax, and they return most of their free cash flow, often referred to as distributable cash flow, to investors in the form of quarterly cash distributions. The average distribution yield now stands at 7.5%, which can be especially appealing to income-oriented investors, particularly in light of today's bond yields of 5% and less.

MLPs also possess a unique tax advantage in that 80% to 90% of distributions typically are tax-deferred for federal income tax purposes. The distributions are subject to tax only when the units are sold, and if the units are held for more than a year, they are taxed as long-term capital gains (currently 15%) rather than ordinary income (marginal rates as high as 35%), as is the case for corporate bonds.

MLP price performance in January illustrates several important characteristics that MLPs historically have demonstrated over longer periods of time--namely low correlation to other equities (prices don't move together) and lower price volatility (prices don't move as greatly). The Westport Resources MLP Index was unchanged over this turbulent past month, while the S&P 500 was down 6%, indicating that low correlation between MLPs and other equities has continued through January (0.37 correlation between MLP Index and the S&P 500 over the past year).

So far, 2008 is shaping up to be a good year, as most MLPs appear poised to feast on the Fed's rate-cut diet. MLP prices in the past have been negatively correlated to interest rates--low rates good, high rates not so good. This shouldn't be too surprising, since a low interest rate environment means lower debt expense for the MLPs and increased interest from investors seeking more attractive yield plays.

Important considerations when evaluating MLPs include distribution growth potential and coverage, cash flow stability, leverage, underlying commodity risk, growth opportunities and capital expenditure plans.

Below are six MLPs that investors might consider purchasing after performing their own due diligence.

MLP Description
Amerigas Partners (APU) Residential and commercial propane distribution
Buckeye Partners (BPL) Pipelines--refined products
Enterprise Products (EPD) Pipelines--natural gas & crude oil
Kinder Morgan Energy Partners (KMP) Pipelines--natural gas, CO2, crude
Oneok Partners (OKS) Natural gas gathering & transportation
Sunoco Logistics Partners (SXL) Pipelines & storage--refined products & crude oil

Disclosure: The Div Guy owns shares of KMP and OKE(OKE owns part of OKS) at the time of this post.

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