The world of Master Limited Partnerships (or MLPs) has to go through adjustments from time to time as investors sometimes wonder about their tax consequences at a time when the government is looking for new tax revenues. Fitch Ratings addressed this possibility just recently. Dividend and income investors have a lot to worry about if this effort picks up any momentum. The good news is that Fitch is not really that worried that MLPs will lose their tax advantages in the near-term and intermediate-term. The bad news is that any fears of this being challenged is likely to bring havoc to the sector and this remains a long-term threat the larger and larger this sector becomes.

MLPs have payouts rather than traditional dividend yields. They are passing on some income out that is taxed, but the tax advantage from so much of the payout comes from the fact that the lion’s share of payouts is structured as a return of capital rather than income. These payouts are to units rather than shares and they can make your taxes harder for some tax preparers as well. So with most MLPs tied to the oil business and with Washington D.C. wanting revenue from wherever it can find it, this tax-advantage situation is a constant threat to the sector. It also needs to be known that MLPs are not the big oil companies that the public generally debates about tax breaks.

Fitch’s take is that any phase-out of the pass-through tax status of U.S. master limited partnerships could bring a significant restructuring of the sector with different implications for both bond and equity holders. Trust us when we say that a change in the tax structure would destroy billions upon billions market value in this MLP sector. As a reminder, MLPs are generally the pipelines and storage systems in the oil and gas sector rather than being in exploration, drilling, and the like.

One key issue to consider is that when this happened in Canada, it was devastating to investors there. Another point is that this may actually trigger M&A activity in the sector. Fitch pointed out that the smaller MLPs would become attractive candidates for merger and acquisition activity. Several positive analyst views have been issued of late and we have covered many of these in recent days and weeks:

• UBS Positive on MLPs
• Deutsche Bank Sees Pipelines & MLPs Rising Big in Q2
• Many MLPs recently raised billions in new investment capital
• Credit Suisse Shows MLPs That Will Thrive Even Under Higher Rates
• Top MLP Stocks (Units) For 2013 from Credit Suisse

Fitch said, “The longstanding focus in Congress on locating new sources of tax revenue and the fact that the sector has seen explosive growth over the last several years highlight the importance of examining any potential impact of a phase-out scenario on MLP issuers… A tax status change would eliminate the cost-of-capital advantage that MLPs have traditionally had in bidding for industry assets against traditional corporate competitors.”

The MLP sector has held up rather well during the recent volatility. JPMorgan Alerian MLP Index ETN (NYSEMKT: AMJ) trades at $45.95 and the all-time high and 52-week high is $46.22. This payout is listed as 4.59%.

Another ETF is the ALPS Alerian MLP ETF (NYSEMKT: AMLP) and at $17.71 it is within a dime of a 52-week and all-time high. Its payout is listed as 5.72%.

One last MLP for this sector is an interesting play as it tracked the junior and smaller market value MLPs that most ETFs overlook. This is the Global X Junior MLP ETF (NYSEMKT: MLPJ) and this new ETF’s indicated payout was closer to 7% but we would stress that this was based solely off of one distribution only so far.

Kayne Anderson MLP Investment Company (NYSE: KYN) is a closed-end mutual fund that uses some leverage for its investors. As of April 1, its investments per share were $57.44 versus net assets of $32.95 per share after backing out items. This mutual fund has a payout “yield” of about 6.4% based on its latest payout.

We would note one more issue on this perceived tax threat on MLPs. A group called the National Association of Publicly Traded Partnerships (or NAPTP) is made up of 134 full and associate members and represent 85 MLPs. This group has the back of MLP investors and it recently sent a letter to the House Ways and Means Committee regarding energy tax reform just on April 15, 2013. Some excerpts are as follows:

• NAPTP strongly recommends that Congress continue to preserve the ability of business enterprises to choose the structure that is the most efficient and effective for their particular business activities, whether it be a pass-through structure or a C-corporation, in any future tax legislation.
• At the end of March the total market capital of MLPs was about $445 billion, of which just under $400 billion was in the natural resource sector.
• The change would affect the value of over 100 MLPs, adversely impacting their direct investors, as well as the investors in dozens of open- and closed-end mutual funds, ETFs, and other investment vehicles whose assets consist wholly or largely of MLPs. Billions of dollars of assets would be devalued with one stroke of the pen.

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