Energy Sector Mutual Funds

- 04.23

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In the United States, a master limited partnership (MLP) is a limited partnership that is publicly traded on an exchange qualifying under Section 7704 of the Internal Revenue Code. It combines the tax benefits of a limited partnership with the liquidity of publicly traded securities.

To obtain the tax benefits of a pass through, MLPs must receive their income from qualifying sources such as from exploration, mining, extraction, refining of oil and gas and the transportation of alternative fuels like biodiesel. To qualify for MLP status, a partnership must generate at least 90 percent of its income from what the Internal Revenue Service (IRS) deems "qualifying" sources. After the 2015 Proposed Regulations from the IRS, only those activities specifically listed related to the production, processing and transportation of oil, natural gas and coal would qualify for favorable tax treatment. In addition, businesses that receive real property rents would qualify if they would meet the requirements of Internal Revenue Code Section 856 pertaining to real estate investment trusts.


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Operation

MLPs pay their investors through quarterly required distributions, the amount of which is stated in the contract between the limited partners (the investors) and the general partner (the managers). Typically, the higher the quarterly distributions paid to limited partners, the higher the management fee paid to the general partner. This provides the general partner with an incentive to maximize distributions through pursuing income-producing acquisitions and organic growth projects. Failure to pay the quarterly required distributions may constitute an event of default.

A general partner in an MLP often begins with a small stake of about 2% in the partnership, but is given incentive distributions from net income after the quarterly required distributions. Since these distributions are usually paid in the form of increased equity claims, the general partner may attain an increased share of the partnership's ownership.

In addition to the traditional governance committees, an MLP has a conflicts committee composed of two or more independent directors. This committee reviews specific matters as authorized by the Board of Directors that may involve conflicts of interest. When selecting the committee members, a general partner should consider the degree of the member's independence from the parent company.


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Taxation

Because MLPs are not taxed on the entity level as regular corporations are, they act as pass-through entities for income tax purposes at both state and federal levels. Additionally, limited partners may also record a pro-rated share of the MLP's depreciation on their own tax forms to reduce liability. This is the primary benefit of MLPs and gives MLPs relatively cheap funding. Some real estate enterprises qualify for a similar tax treatment as a real estate investment trust (REIT). Other publicly traded partnerships, such as Blackstone Group or Cedar Fair, do not qualify for pass-through tax status and must pay federal corporate income taxes.

The tax implications of MLPs for individual investors are complex. While distributions from MLPs are taxed at the marginal rate of the limited partner, there may be no tax advantage to claiming the pro-rated share of the MLP's depreciation when the investment is held in a tax deferred account. In fact, holding MLPs in tax-exempt accounts may generate Unrelated Business Income Tax (UBIT). To encourage tax-exempt investors, some MLPs set up corporation holding companies of limited partner claims which can issue common equity.


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Development

In 1981, Apache Corporation formed the United States' first MLP, Apache Petroleum Company (APC). Apache used the MLP structure to raise capital from smaller investors (for tax-related reasons, MLPs were unsuitable for institutional investors and mutual funds) by offering them a partnership investment in an affordable and liquid security. Apache's success drew other oil and gas companies to the MLP structure. Real estate companies soon followed, and by the mid-1980s, MLPs became so popular that they were adopted in a variety of industries, such as restaurants, hotels and cable TV. Even the Boston Celtics basketball team became an MLP.

In May 2010, the first ever MLP mutual fund was launched, with a stated goal of providing "a high level of inflation-protected income currently through a 7.8 percent distribution yield, which is higher than equity alternatives such as REITs and Utilities." The fund is a part of the SteelPath Mutual Fund Family (now OppenheimerFunds).

On August 25, 2010, the first MLP exchange traded fund (ETF) was launched by Alerian, the company that manages the benchmark MLP index (NYSE: ^AMZ). This fund was similarly designed to the above-mentioned mutual fund in that it avails a new level of diversification to investors and, according to Alerian President Kenny Feng, "provides a single Form 1099, no K-1s, and allows investors to potentially benefit from return of capital and qualified dividend tax treatment of distributions." The fund is known as the Alerian MLP ETF (NYSE: AMLP).

As of December 28, 2013, there were 111 publicly traded master limited partnerships trading on the various stock exchanges in the United States.


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Energy MLPs

Because of the stringent provisions on MLPs and the nature of the quarterly required distributions, the vast majority of MLPs are pipeline businesses, which earn very stable income from the transport of oil, gasoline or natural gas. Energy MLPs are defined as those owning energy infrastructure in the United States, including pipelines, natural gas, gasoline, oil, storage, terminals, and processing plants, though an MLP need not own all of these or be vertically-integrated: even a small section of pipeline or a single railroad tanker car may qualify under the current law.

Source of the article : Wikipedia



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