In last week’s article, I discussed the high yields and relative health of the master limited partnership (MLP) segment of the energy sector. These are primarily the companies that transport and store oil and gas.

While MLP yields are definitely intriguing, MLPs are not for everyone. Today, I want to cover the factors an investor should consider before investing in the space.

MLP Basics

For those unfamiliar with investing in MLPs, here’s a brief review.

In 1987, Congress legislated the rules for publicly traded partnerships in Internal Revenue Code Section 7704. To qualify as an MLP, at least 90% of an MLP’s income must come from qualified sources, such as real estate or natural resources.

An MLP issues units rather than shares. The big advantage for investors is that MLPs aren’t taxed at the corporate level. MLPs pass profits directly to unit-holders in the form of periodic distributions.

This arrangement avoids the double taxation of corporate income and dividends affecting traditional corporations and their shareholders and, all things being equal, should deliver more money to unit-holders.

But the distributions aren’t fully taxed either. Because of the depreciation allowance, 80% to 90% of the distribution is considered a “return of capital” and thus not taxable when received. Instead, returns of capital reduce the cost basis of an investment in the MLP.

The rest of the distribution—typically 10% to 20%—is taxed at the recipient’s income tax rate. Being able to defer the rest of the tax until the investment is sold is a big advantage, since the income can be reinvested to generate compound returns that could more than pay for the eventual tax bill.

When you ultimately sell the units or the cost basis drops to zero, a portion of the capital gain is taxed at the special long-term capital gains tax rate, and the remainder will be taxed at your normal income tax rate.

MLPs issue Schedule K-1 forms instead of the 1099 forms you may receive from a corporation. The K-1 will reflect your share of the taxable income. Partnerships are not required to report their results until April 15 in the following calendar year-end. Most K-1s are issued between late February and early April, which could delay your tax return.

It’s also important to understand that the K-1 package may include a state schedule. This schedule details the MLP’s share of income or loss attributed to each state in which it operates. For example, a pipeline may cut across five states and have reportable income in each state. You may be required to file state tax returns for each of these states, which means your tax reporting may be more complex and costlier. However, most individual investors fall well under the threshold for having to do so.

Alternatives Without Tax Hassles

If you would rather not deal with the tax complications but you still want exposure to an MLP structure, other options exist. You could invest in an MLP that has chosen to be taxed like a corporation. These are mostly MLPs that have headquarters outside the U.S., and which are engaged in marine shipping. You will receive a 1099 instead of a K-1, but you give up some of the tax advantages from the MLP structure.

You can also invest in a mutual fund or an exchange traded fund (ETF) that invests in MLPs. These mutual funds must pay corporate income tax on their earnings, so again you will receive a 1099 for tax reporting. MLP mutual funds also lose some of the tax advantages, but gain diversification over individual MLPs. Whereas individual MLPs may not be appropriate for tax-advantaged accounts like an Individual Retirement Account (IRA) or 401k because of the possibility of having to pay unrelated business taxable income (UBTI), an MLP mutual fund can be more suitable if you want MLP exposure within retirement accounts.

My view is that you first want to make sure that any of your fully taxable investments are protected in retirement accounts to the greatest possible extent before you start to consider putting MLPs in your retirement account. For example, investors with both taxable and tax-deferred investment accounts would generally be better off holding MLPs in the taxable accounts, where their tax deferral benefit would be more valuable, and where they would not generate a liability for unrelated business taxable income.

MLPs and Retirement Accounts

Let’s get back to the topic of UBTI, a primary issue you must understand with MLPs and retirement accounts. UBTI represents earnings of an MLP that aren’t derived from operations, interest, royalties, rent and dividends from the core business.

Investors could have to pay taxes on such income, even in a retirement account. However, the first $1,000 of UBTI generated by a single MLP isn’t taxed. Further, companies must generate at least 90% of income that’s exempt from UBTI. Thus, an investor would need more than $10,000 in income from a single MLP before being at risk of being assessed UBTI taxes in retirement account.

In addition, energy infrastructure MLPs often create “negative” UBTI. So, an investor with a UBTI liability with one MLP can offset it with negative UBTI at another MLP.

The UBTI issue affects a small fraction of investors. You should be so lucky to have to deal with UBTI, because it means your MLP is doing very well.

It is true that you lose some of the tax advantages of holding an MLP in a retirement account, but it’s not as if you are penalized. MLPs generate tax-advantaged income, which is a bonus for non-retirement accounts, but retirement accounts already generate tax-advantaged income.

Investing in MLPs isn’t really as complex as it might sound. There could be some additional tax work, but don’t let that scare you away, because most investors aren’t burdened with too much.

Editor’s Note: As you’ve just witnessed with the above article on MLPs, Robert Rapier is an expert on the energy business. But maybe MLPs aren’t for you. Or maybe you’re looking for a less volatile way to make steady income.

That’s where our colleague Amber Hestla comes in. Amber specializes in generating income using simple but powerful strategies that minimize risk.

Amber also is a military veteran who served in Operation Iraqi Freedom. While deployed overseas with military intelligence, Amber learned how to interpret disparate data to predict likely outcomes. Upon her return to civilian life, she honed this skill to find money-making opportunities.

Amber was stationed in Iraq. She served as a Military Intelligence Analyst (MOS Classification 35F, in military jargon).

For her role in Operation Iraqi Freedom, Amber received the Army Commendation Medal.

She now lives as a Wyoming rancher, raising two children and applying her military intelligence skills to picking investments. She bought her 80-acre ranch with cash…from just five minutes of “work” each day as a trader.

Want to learn Amber’s investment secrets? Click here now for a free demonstration.