I’m still loading up the blog with posts on the basics of MLPs, and this is no exception. But the plan is to eventually dig into current MLP topics, discuss specific MLP’s, etc. So, stay tuned. For today’s post, I wanted to add some more detail on MLP structure by answering some common questions about MLPs.
Why do companies create MLPs?
The MLP structure provides several key benefits to the sponsor that forms the MLP.
All in all, for the right company with the right assets, MLPs can be a very attractive structure. Private equity firms also often create MLPs as an exit route for private equity investments, for many of the reasons listed above.
What is the K-1 statement?
Each MLP investor receives a K-1 statement each year from the MLP that shows his share of the MLP’s income, gain, loss, deductions, and credits. The investor pays tax on the portion of net income allocated to him (which is shielded by losses, deductions, and credits) at his individual tax rate. If the partnership reports a net loss (after deductions), it is considered a “passive loss” under the tax code and may not be used to offset income from other sources. However, the loss can be carried forward and used to offset future income from the same MLP. K-1 forms are usually distributed in late February or early March. (source: Wachovia equity research).
How are Royalty trusts different from MLPs?
U.S. royalty trusts are a type of corporate structure whose primary characteristic is a cash flow stream from a designated set of assets (typically oil and gas reserves) that is paid to shareholders in the form of cash dividends (paid monthly or quarterly).
A trust’s profit is not taxed at the corporate level provided 90% of profit is distributed to shareholders as dividends. Dividends are taxed as personal income. Unlike MLPs, U.S. trusts are not actively managed entities. They do not make acquisitions or increase their assets. Instead, cash flow is paid to investors as it is generated and only until the underlying asset is depleted. Dividends from trusts fluctuate with cash flow and should eventually run out.
In contrast, MLPs are actively managed entities that can make acquisitions and investments to increase their asset base and sustain (and grow) cash flow. Over the long term, MLP distributions are managed to be steady and sustainable, rather than fluctuating like royalty trusts.
Canadian royalty trusts are more similar to MLPs in that they are actively managed entities that make acquisitions and investments to grow production. However, Canadian royalty trusts tend to hedge a smaller percentage of their current production volume than do E&P MLPs.
What are I-shares?
In order to expand the universe of potential investors in MLPs to institutional investors and tax-deferred accounts such as IRAs, an investment vehicle similar to LP units was created known as i-shares (the “I” stands for institutional). Kinder Morgan (KMP) was the first to offer i-shares when it created Kinder Morgan Management, LLC (KMR) in May 2001. The only other i-share company (Enbridge Energy Management – EEQ) followed in October 2002.
I-shares are equivalent to MLP units in most respects, except distributions are paid in stock instead of cash. Distributions to i-shareholders are treated similar to stock splits. The cost basis of the initial investment does not change, but instead, is spread among more shares. One year after purchase, all gains (including the most recent share distribution) are treated as long-term capital gains. Unlike MLP securities, i-shares do not require the filing of K-1 statements and do not generate UBTI. Thus, i-shares can be owned in an IRA account without penalty.
Since inception, both EEQ and KMR have almost always traded at a discount to their associated MLPs, as highlighted in the chart below for KMP / KMR. The discrepancy between valuations occurs for a number of reasons: