First to the acronyms:
MLP stands for Publicly Traded Master Limited Partnerships. These are a kind of tax and legal hybrid, producing an offspring that appears plump and robust, but whose internal workings bear no resemblance to its counterparts in the investment world.
UMA stands for Unified Management Account – an automated conglomeration of multiple individual investor accounts, controlled by a single robot known as a computer program, which automates cash flow, rebalancing, and other investor “services”. Humans not required.
Investors do work with humans, however, who they affectionately refer to as their “investment advisors”. Unfortunately, many investors do not realize that some of these humans have nothing at all to do with managing their portfolios. If you don’t know whether you have a UMA account, ask your advisor. One telltale sign will be pages (sometimes reams) of trades each year across all of your accounts, for no apparent reason, and with no thought whatsoever to tax efficiency or the burden of tax compliance.
MLPs became trendy when energy pipeline businesses decided to reorganize as limited partnerships in an effort to avoid corporate income taxes. They are characterized by their alluring quarterly distributions, which are governed by the partnership agreement. Pipeline businesses have enjoyed historically stable cash flows, so distributions are typically based on some measure of cash flow, and do not represent your share of net income, but are usually quite a bit in excess of it. So, when you receive distributions, the IRS lets you treat this as “return of capital” under the partnership rules, and not as taxable income. Return of capital reduces your tax basis. More on that later.
Everyone thought that MLPs were somewhat immune to energy commodities price risk, but that has not been borne out by the test of time. Now that oil prices have plummeted, so have MLP valuations tanked. It is really dumb to expose your portfolio to unplanned and unknown risks, but most investors with UMA accounts have no idea what the investment manager robot is up to. Dumb, dumb, dumb, dumb…
What’s more, the complex layers of tax compliance which drag down your real rate of return go unmeasured, unacknowledged, and viciously disputed by those trying to sell you these MLPs. And, multiple buys and sells across the range of MLPs you may hold create taxable events that not only subject your portfolio to unnecessary taxation, the amount of taxes due is tricky to unravel given that MLPs unit holders must recapture depreciation under Code Section 751 when a sale takes place.
When you buy a unit, you become a “partner” and that means that various items of income and deductions retain their character and “flow down” to you. That’s not really so bad. The problem is that in order for the MLPs to be Publicly Traded, they are given adverse treatment compared to other passive investments, under IRC Code Section 469(k) (stay with me), which means in plain English that your passive income from one MLP cannot be used to offset your passive loss from another MLP.
But that’s just the beginning of the journey. Each year, an investor will receive a K-1 Form from the MLP showing the various items of income and deductions which must be reported on various forms and schedules in an investor’s tax returns. Often, for MLPs held in UMAs these K-1s will reflect tiny amounts which must still be dutifully recorded, regardless of how time consuming. If the UMA robot has decided to buy and sell tiny tax lots of the MLPs throughout the year, the task of interpreting the K-1 form becomes even more difficult, as it is necessary to reclassify capital gains to ordinary income due to depreciation recapture. Sometimes, this adjustment will create a capital loss and at the same time create ordinary income. Now, that’s really dumb, because capital losses in excess of $3,000 have to be carried forward, whereas ordinary income must be recognized immediately.
Investors were lured into the MLP investment world by the precipitous drop in interest rates after the crash of 2008, being promised high “returns” which often turned out to be just the investor’s own money coming back to them. Retired individuals seeking a safe, low risk cash flow such as was once available from Municipal Bonds and U.S. Treasuries were targeted by promoters. Now, many such investors are finally waking up to what has happened, but unfortunately, they are no richer for the experience.
