The MLPs in our High Yield Income Portfolio and included in the MLP Watch list are a great way to increase the cash flow from your portfolio and to stay well ahead of inflation.
The first master limited partnership in the US was formed by Apache Oil Company in 1981. But it wasn't until 1987 that Congress legislated the rules for publicly traded partnerships as laid out in Internal Revenue Code Section 7704.The rules state that at least 90 percent of an MLP's income must come from qualified sources, such as real estate or natural resources. Section 613 of the tax code requires qualifying energy sources to be depletable resources or their derivatives such as crude oil, petroleum products, natural gas and coal. The range of activities qualifying for MLP treatment has been significantly expanded by the Internal Revenue Service in a series of recent case-by-case rulings.
The main attraction of an MLP from an investor's point of view is that MLPs don't pay corporate income tax. Profits are passed directly to unitholders via (usually) quarterly distributions. This is different than the tax liability faced by shareholders in a corporation. Their profits are taxed first at the corporate level, and then a second time as personal income tax on dividends. In contrast, MLP distributions are taxed just once, at the individual level.But MLP distributions aren't immediately fully taxed either. In fact most of the distribution -- typically 80 to 90 percent -- is classified as a return of capital under the depreciation allowance, which subtracts capital depreciation from net income to account for the fact that assets like pipelines and wells lose value over time.
The depreciation allowance lowers the immediate tax bill but also the cost basis of the MLP investment, resulting in a larger capital gain when the MLP is sold. Over time the tax-deferred income can be invested elsewhere, allowing investors to compound returns that would have otherwise been taxed, while also earning a steady stream of income. This has made MLPs an extremely popular income investment.
The partnerships, in turn, gain access to a broader pool of stable (and as of late cheaper) capital to finance projects. There are currently more than 100 publicly traded MLPs representing some $445 billion in capital. Approximately $400 billion has gone into qualifying energy and natural resource projects, and the vast majority of that -- perhaps 80 percent -- into midstream projects such as oil and gas pipelines