Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Wealthy Families Use MLPs for Tax-Advantaged Income
Transcript
- Lucas: So you've got a client who's sitting on a big taxable portfolio — think fifty million dollars or more — and they want yield, but they don't want the full ordinary-income tax haircut every year. One structure that keeps showing up in family-office allocations is the Master Limited Partnership, or MLP. Luna: MLPs — those are the publicly traded partnerships tied to energy pipelines, right? I feel like they're one of those structures everyone mentions but few really understand. Lucas: Exactly. And that's partly because the tax treatment is genuinely unusual. An MLP is a publicly traded partnership that doesn't pay corporate income tax. Instead, it passes through almost all of its income to unitholders — but here's the key: a lot of that distribution isn't classified as taxable income. It's called a return of capital. Luna: Return of capital — meaning the distribution reduces your cost basis, but you don't pay tax on it until you sell the units. So effectively, you're deferring the tax. Lucas: Right. And if you hold the MLP until death, your heirs get a step-up in basis, and that deferred tax liability disappears entirely. That's a huge advantage for multi-generational wealth. The yield on a typical midstream MLP right now is around six to seven percent, and a large portion of that — historically sixty to eighty percent — is treated as return of capital. Luna: But there's a catch, right? I've heard these things come with a K-1, not a 1099. And K-1s can be a nightmare for tax reporting, especially if you're in multiple MLPs. Lucas: That is the trade-off. The K-1 is more complex — it arrives later, it can have adjustments, and if you have more than a few, your tax preparer might charge you extra. But for a family office or a high-net-worth individual with a solid tax team, the complexity is manageable. The real risk is something else: unrelated business taxable income, or UBTI. Luna: UBTI — that's the kryptonite for MLPs in retirement accounts. If an IRA or 401 holds an MLP and generates more than a thousand dollars of UBTI in a year, the account has to file a tax return and pay tax on that income. It defeats the purpose of tax deferral. Lucas: Exactly. So you generally don't want MLPs inside a tax-sheltered account. Hold them in taxable brokerage accounts where the return of capital treatment actually benefits you. A typical strategy: take the MLP allocation from the taxable side, and move your bond allocation into the IRA to offset the yield. Net result, your overall portfolio yield is more tax-efficient. Luna: And which MLPs are we talking about? The big ones — Enterprise Products Partners, Energy Transfer, Magellan Midstream — those are the dominant names, right? Lucas: Enterprise Products — ticker e p d — is probably the gold standard. It's got a thirty-year track record of distribution growth, investment-grade credit rating, and it's diversified across natural gas, crude oil, and petrochemical pipelines. Energy Transfer — ticker E-T — is larger but has more leverage. Magellan was acquired last year, but there are others like Plains All American or MPLX. Luna: So the investor buys an MLP, gets a six percent yield, most of it tax-deferred, and then they can reinvest that capital into other assets. Over a ten-year period, the compounding effect is significant. Lucas: Significant is an understatement. I ran the math for a client last month. On a five-million-dollar MLP allocation yielding six and a half percent, with seventy percent being return of capital, the annual tax deferral was about two hundred and twenty-seven thousand dollars. If that deferral is reinvested at five percent, over twenty years it's worth roughly seven million dollars in extra wealth. And if the client holds until death, that seven million is never taxed. Luna: That's the kind of number that makes a family office sit up and pay attention. But you mentioned concentration risk — MLPs are almost entirely energy infrastructure. What happens if we get a sustained shift away from fossil fuels? Lucas: That's a real risk, and it's why most family offices cap MLPs at ten to fifteen percent of the portfolio. But it's worth noting that midstream infrastructure — pipelines, storage terminals, export facilities — is largely fuel-agnostic. The same pipes that carry natural gas today could carry hydrogen or carbon dioxide in the future. And many MLPs are already investing in renewable natural gas and carbon capture. Luna: So it's not a pure bet on oil and gas. It's a bet on the physical movement of molecules, whatever those molecules end up being. Lucas: That's exactly the way I'd frame it. And the tax advantages are so structural that even if the energy transition accelerates, the MLP structure itself is likely to persist. The question is just which assets sit inside those partnerships. Luna: I'm curious about the practical side — if a listener wants to add MLPs to their portfolio, how do they do it? Buy individual MLPs or use an ETF or closed-end fund? Lucas: Good question. Individual MLPs give you the pure return of capital treatment and no fund-level expenses. But you need to manage the K-1s and you take single-name risk. The ETF route — like the Alerian MLP ETF, ticker a m l p — gives you diversification and a single 1099 instead of a pile of K-1s. But the ETF itself is a C-corp, so it pays corporate tax on the income it receives from MLPs, which drags on returns. Luna: So you're trading simplicity for efficiency. For a smaller allocation, say under a million, maybe the ETF makes sense. For a larger one, directly owning the MLPs is probably worth the complexity. Lucas: Exactly. And the larger the allocation, the more you should consider building a basket of four to six MLPs to diversify away single-pipeline risk. Some family offices even use a separately managed account with a dedicated manager who handles the K-1s and rebalancing. Luna: That's the kind of infrastructure you need when you're managing serious wealth. And speaking of value — if today's breakdown of MLP tax strategy was useful to you, these episodes stay ad-free because of listener support. You can keep that going at buy me a coffee dot com slash fexingo. Lucas: We don't run ads, we don't have sponsors, and that's by design. So if you get something out of these conversations, that link is how you make sure they keep coming. Luna: Alright, back to the mechanics. One more nuance I want to hit: the difference between distributions and taxable income. Because even though most of the distribution is return of capital, there's still a portion that's taxable as ordinary income. Lucas: Right. Each year, the MLP issues a K-1 that reports your allocable share of taxable income, even if the distribution was larger or smaller than that. The return of capital portion is just the excess of the distribution over your share of taxable income. So you could have a situation where you receive a six percent distribution but only two percent is taxable — the rest reduces your basis. Luna: And if your basis goes to zero, any future distributions become capital gains. But that usually takes many years, especially if the MLP grows its asset base. Lucas: Correct. And if you sell, you pay capital gains on the difference between your sale price and your adjusted basis. That's usually taxed at the long-term capital gains rate, which is lower than ordinary income. So even when you do pay tax, you're paying at a preferred rate. Luna: And if you never sell — you pass the units to heirs — the basis steps up to the market value at death, and all that deferred tax evaporates. That's the ultimate strategy for ultra-wealthy families: buy MLPs, collect tax-deferred income for decades, then pass them on to the next generation tax-free. Lucas: That's exactly the playbook. And it's why you see MLPs in so many multigenerational portfolios. It's not just about yield — it's about yield that compounds without the tax drag. Over thirty years, that difference is enormous. Luna: So let's summarize: MLPs offer high yield, much of it tax-deferred, with the potential for step-up in basis at death. The main downsides are K-1 complexity, UBTI in retirement accounts, and concentration in energy infrastructure. Keep the allocation modest, hold in taxable accounts, and work with a tax advisor who knows the space. Lucas: That's the framework. And I'd add one more thing: MLPs are best for investors in high tax brackets who have a long time horizon. If you're in a low bracket or need liquidity soon, the complexity probably isn't worth it. But for the high-net-worth crowd, it's one of the most powerful tax deferral tools still standing. Luna: And it's a structure that's been around for decades — it's not a loophole that's about to close. The tax code is written to encourage private investment in public infrastructure, and MLPs are the vehicle for that. Lucas: Right. As long as there are pipelines and storage tanks, MLPs will exist. And as long as there are wealthy families looking for tax-efficient income, they'll be allocating to them. Luna: Good place to leave it. Next episode, we'll look at another structure that's flying under the radar for ultra-wealthy investors — maybe something in the insurance space. Lucas: You read my mind. Until then, thanks for listening — and if today's show was valuable, remember the link: buy me a coffee dot com slash fexingo.