Master Limited Partnerships (MLPs) are an interesting beast, especially if you are a dividend growth investor. There are some blue chip size MLPs and they offer nice high yields. However, you can’t invest in MLPs the same way you do other dividend growth stocks. If you make a mistake, you could end up costing yourself time and, most important of all, money.
Before we get into the nitty gritty details, it’s best to understand what an MLP is. At the highest level, an MLP is a type of limited partnership that is also publicly traded, which gives it the tax benefits of an LP and the liquidity of a publicly traded company. Plus, to qualify as an MLP, a company must generate 90 percent of its income from activities relating to the production, processing and transportation of oil. Meeting this requirement allows them to qualify for a tax advantage similar to the treatment REITs get.
So how does this affect us dividend growth investors? Well. the beauty of MLPs is that they are tax advantaged and don’t pay traditional taxes on the corporate or entity level. Instead, they pass on an above average level of their income to investors in the form of dividend payments.
Higher Dividend Yield! But, Wait….
Woohoo higher yield! Well, not so much. Since MLPs are tax advantaged, your dividend payments are technically considered return on capital, at least in the early years. This leads to a whole laundry list of tax accounting steps (that I won’t discuss here) but you’ll need to learn or pay someone to do.
Essentially, you’ll still be able to lower your cost basis through reinvestment similar to regular dividend stocks. However, a portion of your gains will be taxed at a lower capital gains rate, while the portion of the gains that result from lowering your cost basis will be taxed as ordinary income.
Another thing to keep in mind with MLPs is that you should buy them a regular brokerage account and not in your tax sheltered accounts. Since MLPs already have a tax advantage, that becomes null if purchased in a tax sheltered account. If you do, they are considered unrelated business taxable income and then become subject to tax.
I Hate Taxes, Why MLPs Then?
So whats to gain? Well, similar to diversifying by industry, tax diversification is never a bad thing. Hence the popularity of using Roth IRA (pay now), Traditional IRA (pay later) and a 401k (don’t pay if you do it before you pay yourself) when building your retirement accounts. If you’re down to do the leg work that comes with an MLP, it’s one additional step of diversification for your dividend portfolio and also comes with a nice juicy yield.
At the end of the day, aren’t always bad for dividend growth investors and should be considered a useful aspect of a well diversified portfolio, especially if you are looking for additional ways to boost your yield. That doesn’t mean you should go and buy a bunch of MLPs, but it does mean that the options are available if the proper opportunity presents itself.