Your Money: Amid tax worries, MLPs provide some protection

Looking for a hideout from tax hikes? There is tremendous uncertainty and worry surrounding the expiration of the so-called President George W. Bush tax cuts on capital gains and dividend income.

Income investors, in particular, are concerned about potential increases in the basic dividend rate and President Obama's 3.8 percent Medicare surcharge for some higher-income households. Paid together, these proposed rates have the potential to push total dividend taxes up to as high as 43.4 percent from the current 15 percent.

Fortunately, one income play presents a possible tax shield: master limited partnerships.

They are pools of capital that invest mostly in energy, pipelines, oil and gas drilling, and transport. MLPs trade publicly on exchanges and have become more popular as energy agencies have recently dubbed the United States the new "Saudi America" as regards natural gas.

What's the tax shield of MLPs? They pay out what are known as "distributions," also defined as "return of capital," so there is no tax on the majority of the cash payouts. Also, this tax break for these oil and gas investments is a holdover from the 1980s, when they were installed to spur more energy exploration.

Some investors in master limited partnerships believe that if the dividend tax does go up significantly, there could be a rush into the MLP sector as investors seek to increase their after-tax yield.

The after-tax income of dividends could drop by almost 30 percent if dividend income is once again taxed at ordinary income rates in 2013, note the portfolio managers at Yorkville Capital Management L.L.C., in New York, in a recent note to clients. This makes tax-advantaged income of master limited partnerships significantly more attractive.

The prices of these public master limited partnerships enjoyed a strong third quarter in 2012, measured by the Alerian MLP Index, which surged 8.9 percent, vs. a gain of 6.4 percent in the Standard & Poor's 500 benchmark. The Alerian MLP Index gains were driven by MLPs with exposure to growing U.S. domestic oil production.

Many MLPs with oil infrastructure exposure beat expectations and were able to raise their distributions faster than expected, which led to their out-performance in the third quarter.

Two standout performers were Tesoro Logistics L.P and Sunoco Logistics Partners L.P., says David DeWitt, founder of DeWitt Capital, in Wayne. He contends that both partnerships are key players in the development of crude infrastructure, with major pipelines and storage facilities in key shale plays around the country.

However, for the year, they have under-performed the S&P 500, as stocks have rebounded strongly. The Alerian Index is up 8.5 percent in 2012 to date, versus 16.4 percent for the S&P 500.

What drove the relative under-performance? Not all MLPs have good underlying fundamentals, and this year existing companies issued $14.3 billion worth of equity, diluting the share base.

There is a clear distinction in performance between MLP subsectors. For instance, "we stay away from coal LPs," DeWitt said in an interview.

For other oil and gas, and even propane MLPs, "prices are great, politics are tolerable, but what we're seeing is headline risk," DeWitt said.

Still, he says clients are always pleased to hear that master limited partnerships are not taxed on roughly 80 percent to 85 percent of distributions, with the balance taxed at ordinary income rates.

Among DeWitt Capital's top holdings: Atlas Energy L.P. (ATLS); Oneok Partners L.P. (OKS); Magellan Midstream Partners (MMP); Genesis Energy L.P. (GEL); Enterprise Products Partners L.P. (EPD), which is presenting later this month at a Janney Montgomery Scott brokerage conference in Philadelphia; Plains All-American Pipeline, L.P. (PAA); and Atlas Pipeline Partners L.P. (APL).

Some investors expect the out-performance of oil and natural gas-related master limited partnerships to continue, as fundamentals are strong and drilling activity remains robust.

As America continues to move toward energy independence, U.S. growth in domestic production of oil and natural gas equals demand for energy infrastructure. The infrastructure being built is typically backed by decade-long, fee-only contracts that provide visible distribution growth for MLP investors, DeWitt adds.

"We are continuing to focus on liquids-rich shale plays, and the MLPs providing infrastructure in those plays," DeWitt says. "We continue to see value in the gathering and processing subsector. MLPs' healthy yields and growing distributions should continue to attract investment in the current low-rate environment."