Bob Farrell was Merrill Lynch's Chief Market Strategist from 1967-1992.
1. Markets tend to return to long-run averages over time
2. Excesses in one direction are usually followed by excesses in the opposite direction
3. There are no new eras
4. Exponentially rising or falling markets usually go further than you think, but they do not correct by going sideways
5. The public buys the most at the top and the least at the bottom
6. Fear and greed are stronger than long-term resolve
7. Markets are strongest when they are broad based and weakest when they narrow to a handful of blue-chip names
8. Bear markets have three stages - share down, reflexive rebound, and a drawn-out fundamental downtrend
9. When all the experts agree, something else is going to happen
10. Bull markets are more fun than bear markets
Another great investing rule coined by Don Coxe of Cox Advisors, LLC:
"Never invest on the basis of a story on page one, that is the efficient market. Invest on the basis of a story on page sixteen that is on its way to page one."
Tuesday, January 3, 2012
The Taxation of Master Limited Partnerships for Individual Investors
A Master Limited Partnership (MLP) is a limited partnership publicly traded on a securities exchange. The partnership must meet the exception under Code Section 7704(c) that allows it to be taxed as a partnership instead of a corporation. Being a flow through entity, the investor is taxed on his share of the partnership's income, gains, deductions, losses, and other items. Certain investors with large positions may experience state tax issues. Tax information is reported to the investor via Schedule K-1, which may arrive after the April 15th filing deadline.
According to Standard and Poor's, during 2008 the size of the MLP market exceeded $100 billion, with most listings falling in the energy sector. There are at least 100 MLP's currently listed on stock exchanges. MLP's typically engage in the exploration, development, mining, production, processing, refining, transportation, and storage of oil, gas, coal, propane, minerals, timber, certain other natural resources, and certain real property (see StoneMor LP or Cedar Fair for real property examples). Investors are typically drawn to MLP's for high current income.
Some MLP Schedule K-1's suggest a Section 754 disclosure statement be made on the Form 1040 when the partnership investment is purchased because the interest may contain basis adjustments and a Section 751 disclosure statement when the interest is sold. In addition, some Schedule K-1 packages from MLP's include Form 8886 reportable transaction information that may need to be reported on the investor's Form 1040. These are typically small inconveniences and should not dissuade the investor from making an investment.
When the taxpayer sells his partnership units, he generally reports a capital gain or loss determined by the difference between the proceeds received and the taxpayer's adjusted basis in the partnership. However, the MLP is subject to Code Section 751, which may subject part of the realized gain to ordinary income treatment. The ordinary income treatment is related to the investor's share of unrealized receivables, inventory, unrecaptured depreciation for real and tangible personal property, and recapture of depletion taken for intangible drilling and development costs of oil and gas wells, mining development, and exploration expenditures. The allocation between capital and ordinary income is provided by the MLP.
The passive activity loss rules are applied to MLP's on an entity-by-entity basis. The loss from one MLP cannot offset the gain from another MLP. A loss from an MLP cannot be used to offset other sources of passive income. Losses that cannot be deducted will be suspended until there is income from the same MLP that created the loss or the investor sells the MLP. See Code Section 469(k) for more information. One last item to note is portfolio income from the Schedule K-1 will not be offset by any losses reported on the Schedule K-1.
Tax-exempt investors, which includes investors with MLP's held in IRA, SEP,and ROTH retirement accounts and nonprofits, may pay tax on unrelated business income (UBIT) if the gross income from unrelated business income exceeds $1,000 (See IRS Publication 598). If unrelated business income is an issue there are investments such as the JPMorgan Alerian MLP Index ETN, which would avoid UBIT, and provide exposure to the MLP asset class. However, the ETN does expose the investor to credit risk as the investment is essentially an unsecured note from JPMorgan. Additional products have been released which house the MLP investments in a corporation. This eliminates the Schedule K-1 issue for the investor, but creates additional tax issues which lowers over all returns. See "Tax Quirk Crimps Returns of MLP funds (Marketwatch)" for more information. Even so, certain individual investors may choose to gain exposure to MLP's via closed-end funds like those managed by SteelPath. The investor would then avoid the complications caused by Schedule K-1, Section 751 issues when the MLP is sold, state filing requirements, and other disclosure requirements. While MLP's may require cumbersome tax reporting, it should not deter investors from investing in them.
Further reading:
The CPA Journal: Master Limited Partnerships: Tax and Investment Issues
Cohen Fund Audit Services: A Practical Guide to the Tax Issues of Investing in Master Limited Partnerships
National Association of Publicly Traded Partnerships
The December 7th issue of Barron's discussed further tax issues related to Master Limited Partnerships in the article entitled "Even Better Than Bonds." [subscription required]
The article notes that 70% or more of many large master limited partnership's distributions may be tax-deferred because the distributions can be larger than the reported net income of the partnership due to noncash depreciation or amortization expense. The tax-deferred distributions reduce the partner's basis in the partnership. Think of it as a return of invested principal. Eventually, the partner pays tax on the distributions when the interest in the partnership is sold as the distributions reduce the partner's basis in the partnership, assuming the investment is sold at a gain. The portion that is not tax-deferred is typically ordinary income consisting of interest, royalties, and other types of ordinary income.
In addition to the current tax savings, some investors may be able to make the tax-deferred savings permanent by holding the master limited partnership until death. If there is a "step-up" in the basis of the master limited partnership to fair value at death, the prior reduction in basis as a result of the tax free distributions is eliminated.
According to Standard and Poor's, during 2008 the size of the MLP market exceeded $100 billion, with most listings falling in the energy sector. There are at least 100 MLP's currently listed on stock exchanges. MLP's typically engage in the exploration, development, mining, production, processing, refining, transportation, and storage of oil, gas, coal, propane, minerals, timber, certain other natural resources, and certain real property (see StoneMor LP or Cedar Fair for real property examples). Investors are typically drawn to MLP's for high current income.
Some MLP Schedule K-1's suggest a Section 754 disclosure statement be made on the Form 1040 when the partnership investment is purchased because the interest may contain basis adjustments and a Section 751 disclosure statement when the interest is sold. In addition, some Schedule K-1 packages from MLP's include Form 8886 reportable transaction information that may need to be reported on the investor's Form 1040. These are typically small inconveniences and should not dissuade the investor from making an investment.
When the taxpayer sells his partnership units, he generally reports a capital gain or loss determined by the difference between the proceeds received and the taxpayer's adjusted basis in the partnership. However, the MLP is subject to Code Section 751, which may subject part of the realized gain to ordinary income treatment. The ordinary income treatment is related to the investor's share of unrealized receivables, inventory, unrecaptured depreciation for real and tangible personal property, and recapture of depletion taken for intangible drilling and development costs of oil and gas wells, mining development, and exploration expenditures. The allocation between capital and ordinary income is provided by the MLP.
The passive activity loss rules are applied to MLP's on an entity-by-entity basis. The loss from one MLP cannot offset the gain from another MLP. A loss from an MLP cannot be used to offset other sources of passive income. Losses that cannot be deducted will be suspended until there is income from the same MLP that created the loss or the investor sells the MLP. See Code Section 469(k) for more information. One last item to note is portfolio income from the Schedule K-1 will not be offset by any losses reported on the Schedule K-1.
Tax-exempt investors, which includes investors with MLP's held in IRA, SEP,and ROTH retirement accounts and nonprofits, may pay tax on unrelated business income (UBIT) if the gross income from unrelated business income exceeds $1,000 (See IRS Publication 598). If unrelated business income is an issue there are investments such as the JPMorgan Alerian MLP Index ETN, which would avoid UBIT, and provide exposure to the MLP asset class. However, the ETN does expose the investor to credit risk as the investment is essentially an unsecured note from JPMorgan. Additional products have been released which house the MLP investments in a corporation. This eliminates the Schedule K-1 issue for the investor, but creates additional tax issues which lowers over all returns. See "Tax Quirk Crimps Returns of MLP funds (Marketwatch)" for more information. Even so, certain individual investors may choose to gain exposure to MLP's via closed-end funds like those managed by SteelPath. The investor would then avoid the complications caused by Schedule K-1, Section 751 issues when the MLP is sold, state filing requirements, and other disclosure requirements. While MLP's may require cumbersome tax reporting, it should not deter investors from investing in them.
Further reading:
The CPA Journal: Master Limited Partnerships: Tax and Investment Issues
Cohen Fund Audit Services: A Practical Guide to the Tax Issues of Investing in Master Limited Partnerships
National Association of Publicly Traded Partnerships
The December 7th issue of Barron's discussed further tax issues related to Master Limited Partnerships in the article entitled "Even Better Than Bonds." [subscription required]
The article notes that 70% or more of many large master limited partnership's distributions may be tax-deferred because the distributions can be larger than the reported net income of the partnership due to noncash depreciation or amortization expense. The tax-deferred distributions reduce the partner's basis in the partnership. Think of it as a return of invested principal. Eventually, the partner pays tax on the distributions when the interest in the partnership is sold as the distributions reduce the partner's basis in the partnership, assuming the investment is sold at a gain. The portion that is not tax-deferred is typically ordinary income consisting of interest, royalties, and other types of ordinary income.
In addition to the current tax savings, some investors may be able to make the tax-deferred savings permanent by holding the master limited partnership until death. If there is a "step-up" in the basis of the master limited partnership to fair value at death, the prior reduction in basis as a result of the tax free distributions is eliminated.
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