Investors in master limited partnerships should be paying close attention to the restructuring attempts by Linn Energy MLP, because they could mark the start of an ugly precedent for the MLP space.
As originally designed, master limited partnerships were afforded certain tax advantages through the Tax Reform Act of 1986 as a way to attract money into mostly energy-related infrastructure projects.
Even though MLPs are essentially expansive infrastructure systems that transport commodities like oil and natural gas around the country, they have largely been associated with tax management for investment purposes.
Those tax advantages are at risk of fading away, or at least of getting messier than they already are, if Linn Energy's parent company, LinnCo, goes through with a debt-restructuring plan that will
offer investors shares of LinnCo in exchange for their shares in the MLP.
For the MLP investors, the swap could count as a sale for tax purposes, which is about the last thing most of them should want.
Unlike traditional corporations,
MLPs operate as limited partnerships and pay no tax at the company level, allowing investors to avoid the double tax on dividends.
For direct MLP investors, not only are the quarterly distributions deferred until the investment is sold, but most of the distribution actually is a return of capital, which constantly lowers the investor's cost basis.
Over time, the cost basis step-down process could even go into negative territory while the actual share price is climbing, creating the kind of taxable event that most investors would want to avoid.
It is possible that Linn Energy is a kind of canary in the coal mine in an MLP space that is being hit hard by stubbornly low energy prices.
Even though energy prices have been low for a few years, investor money has continued to flow into the MLP space on the premise that MLPs would continue to collect revenues from long-term leases.
Source: Morningstar Inc. *Data through 4/4/2016
The reality has been a different story, according to Howard Erman, president of Erman Retirement Advisory.
“In the summer and fall of 2014, we bought a few MLPs with the understanding that even if we headed into a recession there would be very little problem, because profits would hold up,” he said. “We thought this would insulate us from falling energy prices, because most of the MLPs are on longer-term contracts getting paid in yesterday's energy prices.”
At this point, facing declines of 50% or more on his original investments, Mr. Erman said he is sticking with the plan.
“You've got to hold on to them during this difficult period,” he added.
It is a sad tale for MLP investors who once thought their biggest obstacle was dealing with the complex k-1 tax filing headaches that can involve filing taxes in multiple states.
The fund industry took on that challenge, starting about five years ago, by rolling out mutual funds and various exchange-traded products that invest in MLPs.
Although
packaging MLPs inside a structure such as a mutual fund does provide easy and diversified access to retail investors, it also mutes some of the tax advantages.
For starters, unlike most open-end mutual funds, the MLP funds typically are structured as C corporations and have to pay taxes at the corporate level.
Fund investors also face the same cost basis step-down issues as direct investors, because most of a fund's yield is counted as a return of capital.
In basic terms, consider an MLP fund that owns just one underlying MLP, trading at $100 a share. In the first year, an annual distribution of 7%, or $7, would lower the cost basis by about $5, lowering the original purchase price to $95 for tax purposes.
The remaining $2 worth of annual income would be treated as a dividend distribution taxed first at the corporate level, reducing the payout to the shareholder by about 30%, then at the individual-investor level as dividend income.
Of course, this isn't what most investors and financial advisers are thinking about when tapping into the energy space via MLP funds.
CUTTING LOSSES
Thomas Balcom, founder of 1650 Wealth Management, recently cut his losses on the Tortoise MLP & Pipeline Fund Institutional Class (TORIX) as part of a tax-loss harvesting move.
The fund, which lost 35.8% last year, is up 2.78% so far this year.
The MLP fund category, as tracked by Morningstar, produced an average decline of 34.75% last year, and is down 7.11% this year.
Mr. Balcom, like a lot of advisers, turned to MLP funds for the exposure to the energy sector. But now that he has locked in his losses and licked his wounds, he has shifted his focus toward a more prudent means of exposure in the Energy Select SPDR ETF (XLE).
At 14 basis points, the ETF is a lot cheaper than the mutual fund it replaced, which has an expense ratio of 99 basis points.
Because Mr. Balcom feels strongly that energy has more upside than downside at this point, he's also added two times leverage to the ETF.
“Commodities account for 5% to 10% of my clients' portfolios, and it's been a bloodbath,” he said.
Time will tell if Mr. Balcom's levered upside bet on energy will pay off, but if the correlation between straight-forward and low-cost energy-sector ETFs and MLPs is as close as he believes, it's just one more reason to steer clear of MLPs in all their various forms.
