Earlier this month, Elliott Gue and I conducted an audio conference, now available for readers on the MLP Profits website under the “Audio/Video” tab. See below for answers to questions posed by those who participated.

This week we’re adding Penn Virginia GP Holdings LP (NYSE: PVG) to the Aggressive Portfolio. Penn Virginia GP (PVG) is the general partner (GP) of Penn Virginia Resource Partners LP (NYSE: PVR), a master limited partnership (MLP) that operates a midstream natural gas business and collects royalties from coal mining on its lands.

As Elliott noted last week, GPs are basically leveraged bets on LP assets. In PVG’s case, those assets are coal reserves mined by others and a growing base of midstream natural gas infrastructure in the Marcellus Shale region. The MLP also has assets in Texas and other parts of the South as well as the Midwest.

Despite the ups and downs of energy prices over the past year, coal royalty profits have proved both stable and predictable for management. Relying on royalties rather than producing itself limits legal, regulatory and safety risks. The company holds long-term leases with some 39 operators on 75 different sites, limiting exposure to any one area or company. The company also gets a share of timber and oil and gas royalties on these lands.

The gas midstream business, meanwhile, is mostly fee-based, and the company hedges roughly 60 percent of its commodity exposure as well. Assets are located in areas with long-established natural gas basins with long-lived reserves. The company has signed a joint venture with Range Resources Corp (NYSE: RRC) to develop gathering and transportation systems in the Marcellus Basin in Pennsylvania.

Management continues to look for opportunities to add to assets, inking a deal earlier this month to acquire lands with approximately 10 million tons of Pittsburgh Seam coal reserves in northern West Virginia. The price tag of $17.7 million in cash can be covered internally and is immediately accretive to distributable cash flow.

Penn Virginia Resource Partners (PVR) beat my expectations in 2008 by holding its distributions level, despite the credit crunch and its impact on energy prices. Now expanding once more, the MLP is doubly attractive as a bet on rising energy demand in a recovery.

Yielding nearly 9 percent, PVG is a leveraged way to play PVR. The GP gets 21 percent of PVR’s cash flow. That’s at the low end of GP-LP splits around the industry. But the possibility of lowering capital costs by removing it means PVG is a bona fide target for a high premium deal such as Buckeye Partners LP (NYSE: BPL) ongoing takeover of its general partner. That adds up to some real potential upside.

Parent company Penn Virginia Corp (NYSE: PVA) has now sold its entire interest in the GP, completing a process than began in 2006. That’s now eliminated an overhang to the stock, setting the stage for unit price gains as the distribution resumes its upward trajectory.

Buy Penn Virginia GP Holdings LP up to 20. The next ex-dividend date should be on or about July 30.

The Q-and-A

Question: Is there a withholding tax on Canadian MLPs, and is a tax credit document filed for US investors?

Answer: Actually, US investors are not technically allowed to hold Canadian MLPs. In fact, I’ve been told by the investor relations executive at one of them that doing so is breaking the law, and that US investors wouldn’t be entitled to distributions, per their charter.

I do know of some US investors who have bought in. But these entities are going to be taxed just like Canadian income trusts starting in 2011, so I know of no good reason to buy them. We stick to US MLPs in MLP Profits.

Question: I was surprised at your sell recommendation for AllianceBernstein Holding LP (NYSE: AB). How urgent is the timing? What about Atlas Pipeline Partners LP (NYSE: APL)?

Answer: AllianceBernstein Holding appears to be using carried interest to shelter cash flow from taxes. Should the US government pass legislation doing away with the loophole that allows such treatment, it could face a steep bill–and in fact could be forced to restructure to pay a much lower dividend. That could sent the units back to the lows we saw in 2008. Energy-related MLPs have no such exposure.

Atlas is the kind of company that attracts bargain-hunters. But there are plenty of other infrastructure plays in the Marcellus Shale region that don’t have anything close to its level of debt, and are therefore much better choices. Take a look at MarkWest Energy Partners LP (NYSE: MWE).

Question: What happens to your taxes when return of capital distributions take your cost basis to zero? Is there a step up of cost basis at death?

Answer: Yes to your second question. When enough return of capital has been paid to zero out your cost basis, distributions will be taxed as ordinary income. In practice, however, this won’t happen unless you’ve held for many years.

Question: What’s your opinion on mortgage MLPs?

Answer: We avoid any financial-related MLPs. For one thing, there’s the carried interest issue to worry about. For another, there are just too many good energy-related MLPs out there. Finally, these companies have quite a checkered history for solvency, let alone distribution safety.

Question: I’ve noticed you guys recommend we hold MLPs outside of IRAs. Is there any reason we wouldn’t want to have them inside?

Answer: The main one is opportunity cost. If you hold MLPs in an IRA, you get no benefit from the return of capital portion of your dividend. Then when you pull money out, you pay tax at your ordinary income rate.

On the plus side, IRA custodians must do your paperwork for you, so there are no K-1s to fill out. And unless you have an exceptionally large amount of unrelated business taxable income (UBTI), you’ll incur no additional taxes.

Incidentally, energy-related MLPs–particularly pipelines–often have negative UBTI that can be used to reduce any positive UBTI generated by other MLPs you hold in your IRA. The result is you really have to have institution-sized positions to have any liability.

Question: My accountant tells me that return of capital MLP distributions are deducted from cost basis and then treated as income recapture taxed at ordinary income rates. You say taxes are due as a long-term capital gain when you sell your position. Who’s right?

Answer: Have your accountant check out the MLP Guide on our website. That has an extensive amount of information on how MLP taxes should be filed, including by the way all that’s needed to file these taxes correctly as a long-term capital gain.

Question: Do the premium to net asset value and leverage used affect your opinions on closed-end funds holding MLPs?

Answer: Absolutely. A far lower premium is why we chose Kayne Anderson Energy Total Return Fund (NYSE: KYE) over Tortoise Energy Infrastructure Corp (NYSE: TYG). However, the most important consideration for buying any fund is performance. Kayne Anderson actually tops Tortoise for long-term returns and pays a higher yield as well.

By the way, we still prefer holding individual MLPs to funds. True, the funds are less complicated for tax purposes, as they file a 1099 rather than a K-1. But the yields are lower, and all too often you get the bad and ugly in an industry as well as the good. If you pick them yourself, you’ll always know you own only the best.

Question: What’s your most important criterion for picking an MLP now?

Answer: Distribution coverage by distributable cash flow is the best measure of a sustainable yield, so it’s the single most important number. We also want to see evidence that cash flow can grow, however, and that means picking apart the quality of assets.

You might have noticed we split our Portfolio into three parts. The distinction is how much exposure to volatile energy prices each MLP has. Conservative Holdings generate most or all income from fee-based businesses that aren’t directly affected by energy prices. Aggressive Holdings are mainly energy producers and are therefore affected heavily. And Growth Holdings fall in between, combining fees with energy prices. Conservative Holdings are best if you can’t afford risk, while Aggressive picks have the most upside.

Question: Where do you find historical MLP dividend pay out information that would show amount and consistency since MLP inception?

Answer: The best source would be the websites of the MLPs themselves, which are accessible from the How They Rate table on the MLP Profits website.

Question: Are stocks like United States Natural Gas (NYSE: UNG) MLPs?

Answer: Technically, yes. But they’re not operating businesses. Rather they’re direct plays on commodity prices (UNG is a bet on natural gas prices), and we cover them in How They Rate. They can have major amounts of UBTI, and we’re generally not enthusiastic on them.

Question: Please discuss tax and any other caveats of holding MLPs in a Roth IRA.

Answer: The same provisions with ordinary IRAs cited above apply to other tax-advantaged accounts.

Question: What happens to MLPs when their resource is depleted?

Answer: You’re confusing unit trusts like BP Prudhoe Bay (NYSE: BPT) with master limited partnerships like Linn Energy (NSDQ: LINE). The former are simply royalty streams on an existing asset that depletes over time. Linn and others are operating companies that are constantly replenishing reserves by acquisitions and drilling. They may hurt themselves with bad business decisions but they’re not depleting.

Question: What portion of my overall portfolio should be devoted to MLPs?

Answer: We generally recommend no more than 20 to 25 percent of a portfolio be put into any one sector.

Question: My accountant says that I can wind up owing taxes in several states if I buy MLPs. Is he right?

Answer: Technically, though in practice the amounts owed amount to only a few dollars and no filing is done. You can see state tax information in the Tax Guide on our MLP Profits website.

Question: I have heard horror stories that some MLPs don’t send out K-1s until late March and that even CPAs have trouble interpreting them. Can you comment?

Answer: That was once the way with MLPs. It’s still more complicated than attaching a 1099 to your tax return. But the individual MLPs now do a much better job getting out their information sooner. In fact, you can usually access it on their websites as early as February.

As for interpreting K-1s, Elliott does his filing himself. And any accountant worth their salt should be able to file these things without too much trouble.

Question: What would cause an MLP investment to lose money?

Answer: MLPs are dividend-paying equities. You can lose money if the underlying business sinks, and there were bankruptcies in 2008, such as US Shipping. We spend a lot of time analyzing individual companies’ prospects just as we would any other stock and sell immediately if we see things going askew.

Of course, like all equities, MLP prices fluctuate with market volatility. We generally will ride this out, however. And as 2009 proved, strong MLPs that continue to increase distributions always bounce back from disaster.

Question: How liquid are MLPs?

Answer: All of those we cover are traded either on the New York Stock Exchange or the Nasdaq. Any broker can buy them.

Question: What’s the exposure of master limited partnerships to the BP (NYSE: BP) oil spill in the Gulf of Mexico?

Answer: Not much. Even Enterprise Products Partners LP (NYSE: EPD)–which does operate offshore pipelines–is now far more focused on serving onshore production areas, particularly in shale-rich areas. Enterprise’s current revenue mix is only 1.3 percent affected, and that percentage continues to drop as new shale development continues.

There’s even a good case to be made that MLPs stand to benefit from tighter regulation and higher costs in offshore drilling. That’s because onshore will become more lucrative for producers, as less oil and gas will be produced offshore, crimping supplies and pushing up prices. Pipeline and energy midstream companies will gain more customers and potential fee-generating projects. Producers will benefit from higher prices.

Question: Where can I get a list of all US and Canadian MLPs arranged by country?

Answer: We cover all US MLPs in our How They Rate table on the MLP Profits website. Canadian MLPs, as noted above, are generally off limits to US investors. And with their tax benefits slated to end Jan. 1, 2011, there’s little advantage to owning them.

Question: Can you explain your MLP Safety Rating system?

Answer: We rate MLPs on four criteria. The more met, the higher the rating and the safer the MLP. An MLP rated “4,” for example, would meet all four criteria, while a “0” rated MLP would meet none of the criteria.

The four criteria are:

• Payout ratio–distributions as a percentage of distributable cash flow;
• Debt–lower is better;
• Fee-based revenues as a percentage of total revenue–more is safer;
• Dividend growth.

Note that just because an MLP meets all four criteria doesn’t mean it’s necessarily a buy at its current price. Conversely, MLPs that meet no criteria can also be buys for aggressive investors if the price is right.

Question: What are the best MLPs for conservative income investors?

Answer: Those in the Conservative Portfolio have the least debt, the greatest reliance on fee-based businesses, strong distribution coverage and the most reliable dividend growth. If all you want is safe, high income, they’re the place to focus.