Mlp Investment Risks: What You Need To Know

Master Limited Partnerships (MLPs) are a popular form of investment, offering high yields, tax advantages, and exposure to the oil and gas sector. However, investing in MLPs is not without risk. In this article, we will explore the potential dangers of putting your money into MLPs, including tax complications, industry volatility, and the possibility of losing more than your initial investment. We will also provide guidance on how to minimise these risks and determine if MLPs are a suitable addition to your investment portfolio.

MLPs are subject to volatile commodity prices, especially oil and gas

Master Limited Partnerships (MLPs) are a type of business venture that combines the tax benefits of a private partnership with the liquidity of a publicly traded company. MLPs are often involved in the ownership of oil and gas assets, such as pipelines, and their income is derived from collecting fees for the use of these assets. While MLPs can provide stable revenues and interesting tax advantages, they are subject to volatile commodity prices, especially oil and gas prices.

MLPs are considered to have less exposure to commodity price volatility compared to other energy companies, as their income is based on fees rather than the price of the commodity being transported or stored. However, they are still impacted by fluctuations in oil and gas prices, which can affect the overall demand for their services. For example, a decrease in oil or gas prices can lead to a reduction in production and drilling activity, resulting in lower volumes being transported through MLP-owned pipelines. This, in turn, can impact the revenues and cash flows of MLPs.

The correlation between MLP performance and oil prices is often moderate, and it can be even weaker when considering natural gas prices. This is because MLPs are more reliant on production volumes and pipeline capacity than on energy prices themselves. However, it is important to note that certain subsectors within the MLP industry, such as gathering and processing, are more directly exposed to natural gas price declines.

Despite the impact of volatile commodity prices, MLPs have shown resilience during periods of energy sector volatility. This is due to their fee-based business model, which provides a more stable source of income even when oil or gas prices fluctuate. Additionally, MLPs can benefit from rising energy production, as it leads to higher utilisation rates on their pipelines.

In summary, while MLPs are subject to volatile commodity prices, especially oil and gas, their business model and focus on fee-based revenues provide a level of protection against extreme price fluctuations. However, it is important for investors to carefully consider the specific subsectors and exposures of MLPs before investing, as certain areas within the industry may be more vulnerable to price changes.

MLPs are complex investment vehicles with complicated tax structures

Master Limited Partnerships (MLPs) are complex investment vehicles with a unique tax structure that differs significantly from corporations. MLPs are considered tax-advantaged investments, providing benefits to investors when times are good, but this can turn into a tax nightmare when times are bad.

MLPs are publicly traded partnerships that combine the tax benefits of a private partnership with the liquidity of a publicly traded company. They are treated as limited partnerships for tax purposes, which offers a significant advantage to investors. Unlike corporations, MLPs themselves pay no taxes on their profits. Instead, all profits and losses are passed through to the investors, known as limited partners, who pay income taxes on their portions of the MLP's earnings. This pass-through structure eliminates the double taxation that corporations face, where dividends are taxed at both the corporate and personal level.

The tax implications of MLPs can be complicated, and investors need to be aware of the potential pitfalls. MLPs issue distributions, similar to dividends, that are not taxed when received. Instead, these distributions are treated as a return of capital, reducing the cost basis of the investment. This means that investors will only pay taxes on the difference between the sales price and the adjusted basis when they sell their MLP units.

However, it's important to note that a portion of the distribution is still taxable as ordinary income. Investors receive a K-1 form, which details their share of the partnership's net income, and this amount is taxed at the investor's individual tax rate. Additionally, MLP investors may be required to pay state income taxes in each state the MLP operates, which can increase costs.

Another complexity arises from the potential for "phantom income". If the MLP restructures its debt or enters bankruptcy and has significant debt forgiven, investors may find themselves with a large tax bill on this cashless "income", taxed at ordinary rates. This underlines the importance of monitoring the financial health of MLPs and considering selling at the first sign of financial trouble.

In summary, while MLPs offer tax advantages, their structure can make tax compliance more complicated and costly for investors. The potential for higher taxes and unexpected tax bills during difficult financial periods underscores the complexity of MLPs as investment vehicles.

MLPs are not suitable for investors who require liquidity

Master Limited Partnerships (MLPs) are considered relatively low-risk, long-term investments. They are known for offering slow yet steady investment returns. However, MLPs are not suitable for investors who require liquidity due to several factors.

Firstly, MLPs have limited capital appreciation potential. This is due to the nature of the industries in which MLPs operate, which are typically slow-growing sectors such as pipeline construction and natural resources. As a result, MLPs offer stable and consistent cash distributions rather than significant price appreciation.

Secondly, MLPs can be complex and cumbersome for investors who require liquidity. MLPs have unique tax implications that differ significantly from those of corporations. MLPs are taxed as partnerships, and their profits are passed through to investors, who pay taxes on their portions of the MLP's earnings. This pass-through structure can create additional complexities and costs for investors, especially those who are not familiar with the tax treatment of MLPs.

Additionally, MLPs may not be suitable for investors who require liquidity due to the nature of their distributions. MLPs distribute a significant portion of their income to investors each quarter, and these distributions are treated as a return of capital rather than dividend income. This means that the distributions are not taxed when received but are instead considered reductions in the investment's cost basis, creating a tax liability that is deferred until the MLP units are sold. As a result, MLPs may not provide the level of liquidity desired by investors who require more immediate access to their investments or who are seeking more frequent distributions.

Furthermore, MLPs are not allowed in most tax-deferred or tax-free accounts, such as traditional or Roth IRAs. This is because the cash distributions received by MLP investors are considered unrelated business taxable income (UBTI), which can create a tax liability for certain types of investment funds. Therefore, MLPs are typically held in regular brokerage accounts, which may not align with the liquidity preferences of certain investors.

In conclusion, while MLPs offer a combination of tax advantages and liquidity, they may not be suitable for investors who require high levels of liquidity due to their limited capital appreciation, complex tax implications, deferred taxation on distributions, and restrictions on certain types of investment accounts.

MLPs are not suitable for retirement accounts

MLPs, or Master Limited Partnerships, are publicly traded partnerships that are often engaged in the transportation, storage, production, or mining of minerals and natural resources. They are considered relatively low-risk, long-term investments, providing a slow but steady income stream.

However, there are several reasons why MLPs are not suitable for retirement accounts:

Tax Benefits

One of the main reasons investors are attracted to MLPs is their tax benefits. MLPs are taxed as partnerships, not corporations, so their profits are not subject to double taxation. Instead, the MLP itself pays no taxes, and the income is passed on to the partners, who are taxed on their share. This tax structure can be advantageous for investors with taxable accounts.

However, when it comes to retirement accounts like IRAs or 401(k)s, the income is already tax-deferred, so the tax benefits of an MLP are essentially wasted. In fact, holding MLPs in a retirement account can result in unexpected tax complications and even result in the account owing tax.

Unrelated Business Income Tax (UBIT)

When an IRA invests in an MLP, it becomes a limited partner and is considered to be "earning" its share of the MLP's business income. However, this income is not related to the retirement account's tax-exempt purpose, and therefore it is treated as Unrelated Business Taxable Income (UBTI).

The tax is owed on the retirement account's share of the MLP's taxable business income, and the tax rate is currently 37%. While there is a deduction for the first $1,000 of UBTI, any amount over this threshold will be subject to tax. This can result in unexpected tax bills and added complexity for retirement account holders.

Volatility and Risk

While MLPs are considered low-risk investments, they tend to be more volatile than stocks and bonds. They are also more complicated and require extensive research. MLPs are best suited for sophisticated investors with a higher risk tolerance than the average investor. For those seeking to invest for the long term, such as retirement, a more stable and less complex investment option may be preferable.

In conclusion, while it is legally permissible to hold MLPs in a retirement account, there are several important considerations that make them unsuitable for this purpose. The tax benefits of MLPs are wasted in a tax-deferred account, and the potential for unexpected tax bills can offset the benefits of the investment. Additionally, the volatile nature of MLPs may introduce more risk than is desirable for retirement savings. Therefore, it is generally advisable to consult with a tax advisor and consider alternative investment options for retirement accounts.

MLPs are subject to industry-specific risks

Since most MLPs are clustered in the energy sector, they are sensitive to shifts in oil and gas prices. MLPs can be very risky investments as they fluctuate greatly with the price of oil and gas. Usually reserved for sophisticated and high-net-worth investors, these investments are not suitable for the average investor. The 2015-16 decreases in oil prices are an example of this.

MLPs are also subject to the possibility of legislation or regulations that impact these industries.

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