Dividend Crazy: Get Mile-High Dividends from This Tax-Free Wealth Pumper

By Elliott H. Gue, Chief Analyst of Energy & Income Advisor

1. The Case for MLPs: High Yields, Deferred Taxes

Energy-related master limited partnerships (MLP) offer high yields and significant tax advantages, a compelling proposition in the current low-yield environment.

The Alerian MLP Index sports a distribution yield of 5.7 percent, though the capitalization-weighted structure of this benchmark means that the 10 largest MLPs by market capitalization have an outsized effect on this metric. On an equal-weighted basis, the 50 stocks that make up the Alerian MLP Index have an average yield of more than 7 percent.

By either measure, the Alerian MLP Index offers a superior yield to security classes favored by many income-seeking investors. Neither the Bloomberg North American REIT Index, which tracks a group of 126 real estate investment trusts, nor the Philadelphia Stock Exchange Utility Index, which comprises 20 electric utilities, can compete with the MLP benchmark on yield.

To match the distribution yield offered by the Alerian MLP Index, a bond investor would need to consider BB-rated corporate issues or worse. But before you venture into junk-rated bonds, remember that the coupons paid out by fixed-income securities remain the same for their duration.

In contrast, the typical MLP in the Alerian MLP Index has boosted its payout at an average annual rate of almost 5.5 percent over the past three years. That’s more than double the dividend growth rate for stocks in the Bloomberg North American REIT Index and the Philadelphia Stock Exchange Utility Index.

Although many income-seeking investors gravitate toward the highest-yielding names, a growing distribution can boost your total return significantly over time.

The Tax Reform Act of 1986 sought to encourage investment in the domestic energy industry by exempting MLPs from corporate-level taxation. Similar to real estate investment trusts, MLPs pass through the majority of their profits, losses and deductions to unitholders–the MLP equivalent of shareholders–who pay personal income taxes on their share of taxable profits. In this way, MLPs investors avoid the double taxation–first at the entity level and then at the individual level–that’s part and parcel with corporate dividends.

The distributions paid by MLPs are credited directly to your brokerage account. But unlike a regular dividend, the IRS considers these distributions a return of capital that reduces your cost basis in the MLP but isn’t taxed until you sell your position.

At the end of the tax year, the MLPs in which you’ve invested will send you a Form K-1 that details your share of the partnerships’ profits, losses, deductions and tax credits to help determine your tax obligation.

On average, the unitholders’ share of the MLP’s taxable income comes to about 20 percent of the total distribution paid over the course of the year; this amount is taxed at the individual’s ordinary income tax rate. In other words, the taxes on about 80 percent of the distributions you receive will be deferred until you sell your position in the MLP.

An example will help to explain the intricacies of MLP taxation.

Let’s say you purchased 100 units of an MLP for $10 per unit (a total cost of $1,000) and collected $100 in distributions. If the MLP were to allocate $1.00 of net income and $0.80 in depreciation and other noncash charges to each common unit, you’d have to pay taxes on this $20 ($0.20 x 100 units) of allocated net income. In this example, your cost basis would decline to $920 from the initial $1,000 invested. If the same situation were to play out in the following year, you would once again pay taxes on $20 in allocated earnings, and your cost basis would drop to $840.

Let’s add a new wrinkle. The stock appreciates to $15 per unit in the third year, prompting you to liquidate your 100-unit position for a $1,500 gain. At this point, you’d be liable for ordinary income tax on $160–the difference between your adjusted cost basis of $840 and your original cost of $1,000. You’d also have to pay long-term capital gains taxes on $500, the difference between your initial cost and the price at which you sold the units.

It’s always a good idea to keep track of purchases and sales on your own, though the Form K-1 sent to you annually by the MLP will contain all the information you need to calculate your adjusted cost basis and determine your tax obligations.

The potential to defer taxation on your allocated income for years gives you more capital to put to work elsewhere. These securities have also become popular in estate planning; the cost basis resets to the fair market when the unitholder dies, allowing the heir to avoid taxation on previous distributions.

The noncash charges that shield some of an MLP’s cash flow from immediate taxation are the same reasons that traditional earnings-related metrics provide scant insight into a publicly traded partnership’s financial performance.

Although earnings include a number of charges such as depreciation and mark-to-market valuations of all outstanding oil and gas hedges, these noncash items don’t impede or enhance an MLP’s ability to pay its quarterly distribution.

For example, many MLPs own midstream assets that move, process and store oil, natural gas and natural gas liquids. Despite mounting depreciation charges, a pipeline doesn’t reach the end of its economic life once an accountant has written it off the books; routine maintenance and repair can ensure that a pipeline operates for decades. Moreover, MLPs in recent years have reversed, rerouted and expanded older pipelines to take advantage of shifting energy flows in the wake of the shale oil and gas revolution. Written off long ago, these assets now enjoy a new lease on life.

Although depreciation charges may be a conceptual headache for those who are accustomed to generally accepted accounting principles (GAAP), these noncash items are a big part of the reason why much of the income you receive from an MLP is taxed as a return of capital.

Publicly traded partnerships that own and operate oil- and gas-producing assets tend to hedge their production for years in advance to insulate their cash flow from the vagaries of the commodities markets.

GAAP requires that companies mark these hedges to market each quarter, regardless of which period these futures contracts cover. In virtually all cases, partnerships don’t need to post additional collateral or make margin payments based on the changing value of their hedges; these mark-to-market losses or gains have no bearing on cash flow.

Instead of earnings, investors should monitor an MLP’s distributable cash flow (DCF), a non-GAAP metrics that’s calculated by adding back depreciation and other noncash charges to net income and subtracting capital expenditures on maintenance. By following the cash flow, we can get a sense of the margin of safety backing up an MLP’s quarterly payout.

MLPs and Tax-Advantaged Accounts

Investors often ask if MLPs are appropriate for tax-advantages accounts such as an IRA or a 401(k). Although it isn’t illegal to hold MLP units in a retirement account, we’re firmly of the opinion that these securities are better-suited for taxable portfolios.

For one, we prefer to hold securities that offer no tax protections in a retirement account and keep our MLP positions in a taxable account to take full advantage of their tax-deferral characteristics.

Also, some of the net income that MLPs allocate to their unitholders is classified as unrelated business taxable income (UBTI). Each taxpayer has a $1,000 total annual allowance for UBTI paid into a 401(k) or IRA account; annual UBTI over this threshold could incur a tax liability. However, many MLPs generate negative or modest levels of UBTI, ensuring that you likely won’t have to lose sleep over this issue.

If you exceed your annual UBTI exemption, you don’t need to file any additional forms with the IRS; the custodian of your IRA or 401(k) is responsible for filing a Form 990 and paying the tax out of your account’s funds. Most investors find that the above-average yields offered by MLPs more than compensate for any UBTI-related taxes.

Some investors avoid these problems altogether by purchasing a close-end or exchange-traded fund, neither of which produce UBTI. These investment products also disburse normal, qualified dividends to their shareholders and report these payments on a Form 1099, eliminating any vexation that might arise from dealing with the unfamiliar Form K-1.

However, these minor conveniences don’t make up for the biggest problem with closed-end and exchange-traded funds: portfolios that skew heavily toward names with the largest capitalization.

2.
Our Favorite High-Yielding Master Limited Partnership

Mid-Con Energy Partners LP (NSDQ: MCEP) went public in late 2011 but pursues a much different strategy than its peers, using an enhanced recovery technique called water-flooding to extract crude oil from mature fields in Oklahoma, Kansas and Colorado.

The old rule of thumb held that water-flooding can recover about 50 percent of the oil volumes extracted during primary production, though the exact rate depends on geologic conditions and project design. Over the years, technological advances and a better understanding of oil-field geology has made this old rule of thumb conservative.

Mid-Con Energy Partners estimates that its total reserves at about 10 million barrels of oil equivalent, 99 percent of which is crude oil. About 96 percent of the MLP’s properties are in production and have been water-flooded.

Southern Oklahoma contains about 55 percent of Mid-Con Energy Partners’ total reserves and is home to five major developments, including the MLP’s two largest fields, Highlands and Battle Springs. The partnership’s predecessor began injecting water into the Highlands play in 2008, with the first improvement in the production rate coming in 2009. Battle Springs’ received its first water injection in September 2006, and the output rate first perked up in December of the same year.

With Mid-Con Energy Partners’ fields in southern Oklahoma still in the early stages of secondary recovery, management expects production to climb in coming years. Production in this area has staged a remarkable comeback, growing to almost 2,500 barrels of oil per day from a mere 220 barrels of oil per day in September 2006.

Northeast Oklahoma is home to about one-third of the MLP’s proven reserves. Two of the largest plays in this region, the Cleveland and Cushing, have been in secondary production for a long time, though start date of these efforts varies by lease. Although output from these fields continues to diminish, management has taken steps to slow the rate of decline, including in-fill drilling between producing wells, recompleting existing wells and expanding the flood zone to new portions of the field.

Mid-Con Energy Partners’ assets in the Hugoton Basin account for about 10 percent of the MLP’s total reserves and have passed their peak production. Nevertheless, the War Part I and the War Part II in Texas County, Okla., still generate an economic return and produce more than 230 barrels of oil equivalent per day.

Acquisitions will be the primary driver of distribution growth for Mid-Con Energy Partners. In the second quarter, the MLP announced a $16.4 million deal–about $27 per barrel of proven oil reserves–to purchase additional working interests in fields surrounding its core operations.

This miniscule deal has its merits, but we expect drop-down transactions from Mid-Con Energy III and Mid-Con Energy IV, two investment funds affiliated with the partnership’s general partner and Yorktown, an energy-focused private-equity firm that controls almost half of the MLP’s outstanding units. Yorktown the two investment funds in June 2011 to buy and develop water-flood projects at various stages of development, with the goal of selling these assets to Mid-Con Energy Partners.

Mid-Con Energy III and Mid-Con Energy IV effectively serve as project incubators, buying properties suitable for water-flooding and investing in these fields until production recovers to a level that justifies dropping down the acreage to the MLP. Yorktown sizable equity stake Mid-Con Energy Partners incentivizes the private-equity firm to sell assets to the MLP at prices that will enable the firm to grow its distribution.

With prices for oil-bearing acreage out of reach for many upstream MLPs, Mid-Con Energy Partners stands out for the potential to grow production through reasonably priced drop-down transactions. Please consult the Energy & Income Advisor website for an updated buy target.

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About Elliott H. Gue

Elliott Gue knows energy. Since earning his bachelor’s and master’s degrees from the University of London, Elliott has dedicated himself to learning the ins and outs of this dynamic sector, scouring trade magazines, attending industry conferences, touring facilities and meeting with management teams.

In a world where anyone and everyone can broadcast his or her opinion and volume tends to drown out reason, individual investors have come to prize Elliott’s in-depth knowledge and rational assessment of the companies and the markets he covers.

When fear-mongering pundits claimed that the Macondo oil spill marked the end of offshore drilling, Elliott Gue provided a welcome dose of reality, explaining to attendees of the 2010 San Francisco MoneyShow why the death of deepwater exploration and production was greatly exaggerated. Investors who heeded this contrarian call raked in impressive gains on shares of contract drillers and equipment providers.

This and other prescient investment calls prompted the official program for the 2008 G-8 Summit in Tokyo to call Elliott Gue “the world’s leading energy strategist.” He has also appeared on CNBC and Bloomberg TV and has been quoted in a number of major publications, including Barron’s, Forbes and the Washington Post.

In October 2012, Elliott Gue launched the Energy & Income Advisor, a semimonthly online newsletter that’s dedicated to uncovering the most profitable opportunities in the energy sector, from growth stocks to high-yielding utilities, royalty trusts and master limited partnerships.