A master limited partnership (MLP) is a business venture that exists in the form of a publicly traded limited partnership. It combines the tax benefits of a partnership with the liquidity of a public company. Master limited partnerships (MLPs) are a business venture that exists in the form of a publicly traded limited partnership. They combine the tax benefits of a private partnership—profits are taxed only when investors receive distributions—with the liquidity of a publicly-traded company (PTP).

A master limited partnership trades on national exchanges. MLPs are situated to take advantage of cash flow, as they are required to distribute all available cash to investors. They can also help reduce the cost of capital in capital-intensive businesses, such as the energy sector.

The first MLP was organized in 1981. However, by 1987, Congress effectively limited the use of them to the real estate and natural resources sectors. These limitations were put into place out of a concern over too much lost corporate tax revenue since MLPs do not pay federal income taxes.

An MLP is treated as a limited partnership for tax purposes. A limited partnership has a pass-through, or flow-through, tax structure. This taxing method means that all profits and losses are passed through to the limited partners. In other words, the MLP itself is not liable for corporate taxes on its revenues, as most incorporated businesses are. Instead, the owners—or unitholder investors—are only personally liable for income taxes on their portions of the MLP’s earnings.

This tax scheme offers a significant tax advantage to the MLP. Profits are not subject to double taxation from corporate and unitholder income taxes. Standard corporations pay corporate tax, and then shareholders must also pay personal taxes on the income from their holdings. Further, deductions such as depreciation and depletion also pass through to the limited partners. Limited partners can use these deductions to reduce their taxable income.

To maintain its pass-through status, at least 90% of the MLP’s income must be qualifying income. Qualifying income includes income realized from the exploration, production, or transportation of natural resources or real estate. In other words, to qualify as a master limited partnership, a company must have all but 10% of its revenues be from commodities, natural resources, or real estate activities. This definition of qualifying income reduces the sectors in which MLPs can operate.

Quarterly distributions from the MLP are not unlike quarterly stock dividends. But they are treated as a return of capital (ROC), as opposed to dividend income. So, the unitholder does not pay income tax on the returns. Most of the earnings are tax-deferred until the unitholder sells their portion. Then, the earnings receive the lower capital gains tax rate rather than at the higher personal income rate. This categorization offers significant additional tax benefits.

Like any investment, MLPs have their pros and cons. MLPs may not work for all investors. Also, an investor must offset the disadvantages against any benefits of holding units of MLPs before they invest.

MLPs are known for offering slow investment opportunities. The slow returns stem from the fact that MLPs are often in slow-growing industries, like pipeline construction. This slow and steady growth means MLPs are low risk. They earn a stable income often based on long-term service contracts. MLPs offer steady cash flows and consistent cash distributions.

The cash distributions of master limited partnership usually grow slightly faster than inflation. For limited partners, 80%-90% of the distributions are often tax-deferred. Overall, this lets MLPs offer attractive income yields—often substantially higher than the average dividend yield of equities. Also, with the flow-through entity status and by avoiding double taxation, it leads to more capital being available for future projects. The availability of capital keeps the MLP firm competitive in its industry.

Further, for the limited partner, cumulative cash distributions usually exceed the capital gains taxes assessed once all units are sold.

There are benefits for using MLPs for estate planning, as well. When unitholders gift or transfer the MLP units to beneficiaries, both will avoid paying taxes during the time of transfer. The cost basis will readjust based on the market price during the time of the transfer. Should the unitholder die and the investment pass to heirs, their fair market value is determined to be the value as of the date of death. Also, earlier distributions are not taxed.

Pros

• Steady income
• Low risk
• Tax-advantaged treatment
• Liquid

Cons

• Complex tax-filing
• Limited appreciation
• Limited to two industries

Perhaps the biggest hassle to being an MLP limited partner is that you will have to file the infamous Internal Revenue Service (IRS) Schedule K-1 form. The K-1 is a complicated form and may require the services of an accountant—even if you did not sell any units. Also, K-1 forms are notorious for arriving late, after many tax preparers thought they had completed their taxes. Also, as an added problem, some MLPs operate in multiple states. Income received may require state tax returns filed in several states, which will increase your costs.

Another tax-related negative is that you cannot use a net loss—more losses than profits—to offset other income. However, net losses may carry forward to the following year. When you eventually sell all your units, a net loss can then be used as a deduction against other income.

A final negative is limited upside potential—historically—but this is to be expected from an investment that is going to produce a gradual yet reliable income stream over several years.

Most MLPs currently operate in the energy industry. An energy master limited partnership (EMLP) will typically provide and manage resources for other existing energy-based businesses. Examples might include firms that provide pipeline transportation, refinery services, and supply and logistics support services for oil companies.

Many oil and gas firms will issue MLPs instead of shares of stock. With this structure, they can both raise capital from investors while still maintaining a stake in operations. Some corporations may own a sizable interest in its MLPs. Separate stock-issuing companies are also set up, with their sole interest being to own units of the corporate’s MLP. This structure allows redistributing the passive income through the corporation as a regular dividend.

A good example of this structure was Linn Energy, Inc., which had both an MLP (LINE) and a corporation that owned an interest in the MLP (LNCO). Investors had the option to choose—for tax purposes—how they would like to receive the income the company generated.

The firm was dissolved in 2017 after filing for bankruptcy in 2016. It was reorganized in 2018 as two new companies Riviera Resources and Roan Resources. Investors in LINE were given an exchange offer, to convert their units into shares of the new entities.

DownREIT is a joint endeavor between a real estate owner and a real estate investment trust (REIT) for the purpose of acquiring and controlling real estate.

KEY TAKEAWAYS

• A DownREIT is a partnership agreement between an REIT and a real estate owner that enables deferring of tax on sale of appreciated real estate.

• There are two types of DownREITs. The first type involves limited to no capital contributions from REITs while the second type involves significant capital contribution by REITs.

• DownREITs are more complicated as compared to UPREITs and can have tax implications, if the operating unit is considered a security by the IRS.

DownREIT involves a partnership arrangement between a real estate owner and the (REIT) that assists the real estate owner in deferring capital gains tax on ths sale of appreciated real estate. The UPREIT was invented after the real estate recession of the 1990s to facilitate investment of capital into the real estate industry. DownREIT evolved out of the UPREIT.

Real estate owners who contribute property to DownREITs receive operating units in a partnership. This partnership entity and the property owner’s relationship to it can be structured in a variety of different ways, depending on the structure of the REIT and any UPREITs that may exist. In a DownREIT, the REIT has to agree to a standstill or lockout agreement for sale of contributed assets.

There are two types of DownREIT partnership categories. In the first type of partnership, REIT provides limited to no capital and limited partners receive preferences on distribution of operating cash in an amount equal to REIT share dividends. The second category of REIT involves contribution of significant capital by the REIT. The general partner receives distribution equal to return of capital.

An example of a DownREIT is as follows:

Consider a portfolio of five properties valued at $100 million. The properties have debt equal to $80 million at 8% interest rate. The partners who own the property have a cumulative capital account balance of $5 million. The REIT enters the transaction and pays off $60 million of existing debt for the property and replaces capital account balances for the remaining partners with debt at 7%. Shares are issued as operating units for the remaining $20 million held by partners and the REIT becomes the majority holder while the remaining partners become GPs and LPs.

DownREIT is a joint venture between a real estate owner and a real estate investment trust to defer capital gains tax on the sale of real estate. more

A hedge fund is an aggressively managed portfolio of investments that uses leveraged, long, short and derivative positions. Hedge funds are alternative investments using pooled funds that employ different strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). It is important to note that hedge funds are generally only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles.

Each hedge fund is constructed to take advantage of certain identifiable market opportunities. Hedge funds use different investment strategies and thus are often classified according to investment style. There is substantial diversity in risk attributes and investments among styles.

Legally, hedge funds are most often set up as private investment limited partnerships that are open to a limited number of accredited investors and require a large initial minimum investment. Investments in hedge funds are illiquid as they often require investors to keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.

KEY TAKEAWAYS

• Hedge funds are alternative investment vehicles that employ a variety of strategies to generate alpha for their accredited investor clients.
• They are more expensive as compared to conventional investment instruments because they have a Two And Twenty fee structure, meaning they charge two percent for asset management and take 20% of overall profits as fees.
• They have had an exceptional growth curve in the last twenty years and have been associated with several controversies.
  

A former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co. launched the first hedge fund in 1949. It was while writing an article about current investment trends for Fortune in 1948 that Jones was inspired to try his hand at managing money. He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage to enhance returns.

In 1952, Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner. As the first money manager to combine short selling, the use of leverage shared risk through a partnership with other investors and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.

Hedge funds went on to dramatically outperform most mutual funds in the 1960s and gained further popularity when a 1966 article in Fortune highlighted an obscure investment that outperformed every mutual fund on the market by double-digit figures over the previous year and by high double-digits over the previous five years.

However, as hedge fund trends evolved, in an effort to maximize returns, many funds turned away from Jones’ strategy, which focused on stock picking coupled with hedging and chose instead to engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the bear market of 1973-74.

The industry was relatively quiet for more than two decades until a 1986 article in Institutional Investor touted the double-digit performance of Julian Robertson’s Tiger Fund. With a high-flying hedge fund once again capturing the public’s attention with its stellar performance, investors flocked to an industry that now offered thousands of funds and an ever-increasing array of exotic strategies, including currency trading and derivatives such as futures and options.

High-profile money managers deserted the traditional mutual fund industry in droves in the early 1990s, seeking fame and fortune as hedge fund managers. Unfortunately, history repeated itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds, including Robertson’s, failed in spectacular fashion. Since that era, the hedge fund industry has grown substantially. Today the hedge fund industry is massive—total assets under management in the industry are valued at more than $3.2 trillion according to the 2018 Preqin Global Hedge Fund Report. Based on statistics from research firm Barclays hedge, the total number of assets under management for hedge funds jumped by 2335% between 1997 and 2018.

The number of operating hedge funds has grown as well. There were around 2,000 hedge funds in 2002. Estimates vary about the number of hedge funds operating today. This number had crossed 10,000 by the end of 2015. However, losses and underperformance led to liquidations. By the end of 2017, there are 9754 hedge funds according to research firm Hedge Fund Research.

Key Characteristics

• They’re only open to “accredited” or qualified investors: Hedge funds are only allowed to take money from “qualified” investors—individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. As such, the Securities and Exchange Commission deems qualified investors suitable enough to handle the potential risks that come from a wider investment mandate.

• They offer wider investment latitude than other funds: A hedge fund’s investment universe is only limited by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies. Mutual funds, by contrast, have to basically stick to stocks or bonds and are usually long-only.

• They often employ leverage: Hedge funds will often use borrowed money to amplify their returns. As we saw during the financial crisis of 2008, leverage can also wipe out hedge funds.

• Fee structure: Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee. This fee structure is known as “Two and Twenty”—a 2% asset management fee and then a 20% cut of any gains generated.

There are more specific characteristics that define a hedge fund, but basically, because they are private investment vehicles that only allow wealthy individuals to invest, hedge funds can pretty much do what they want as long as they disclose the strategy upfront to investors. This wide latitude may sound very risky, and at times it can be. Some of the most spectacular financial blow-ups have involved hedge funds. That said, this flexibility afforded to hedge funds has led to some of the most talented money managers producing some amazing long-term returns.

It is important to note that “hedging” is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market. (Mutual funds generally don’t enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn’t accurate to say that hedge funds just “hedge risk.” In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

Below are some of the risks of hedge funds:

•   Concentrated investment strategy exposes hedge funds to potentially huge losses.

•   Hedge funds typically require investors to lock up money for a period of years.

•   Use of leverage, or borrowed money, can turn what would have been a minor loss into a significant loss.
  

Hedge fund managers are notorious for their typical 2 and 20 pay structure whereby the fund manager receives 2% of assets and 20% of profits each year. It’s the 2% that gets the criticism, and it’s not difficult to see why. Even if the hedge fund manager loses money, he still gets 2% of assets. For example, a manager overseeing a $1 billion fund could pocket $20 million a year in compensation without lifting a finger.

That said, there are mechanisms put in place to help protect those who invest in hedge funds. Often times, fee limitations such as high-water marks are employed to prevent portfolio managers from getting paid on the same returns twice. Fee caps may also be in place to prevent managers from taking on excess risk.

How to Pick a Hedge Fund

With so many hedge funds in the investment universe, it is important that investors know what they are looking for in order to streamline the due diligence process and make timely and appropriate decisions.

When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each. These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the top five highest-performing funds in a particular category.

For a list of the biggest hedge funds in the world read, “What are the Biggest Hedge Funds in the World?”

The first guideline an investor should set when selecting a fund is the annualized rate of return. Let’s say that we want to find funds with a five-year annualized return that exceeds the return on the Citigroup World Government Bond Index (WGBI) by 1%. This filter would eliminate all funds that underperform the index over long time periods, and it could be adjusted based on the performance of the index over time.

This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long/short funds, and several others. But if these aren’t the types of funds the investor is looking for, then they must also establish a guideline for standard deviation. Once again, we will use the WGBI to calculate the standard deviation for the index over the previous five years. Let’s assume we add 1% to this result, and establish that value as the guideline for standard deviation. Funds with a standard deviation greater than the guideline can also be eliminated from further consideration.

Unfortunately, high returns do not necessarily help to identify an attractive fund. In some cases, a hedge fund may have employed a strategy that was in favor, which drove performance to be higher than normal for its category. Therefore, once certain funds have been identified as high-return performers, it is important to identify the fund’s strategy and compare its returns to other funds in the same category. To do this, an investor can establish guidelines by first generating a peer analysis of similar funds. For example, one might establish the 50th percentile as the guideline for filtering funds.

Now an investor has two guidelines that all funds need to meet for further consideration. However, applying these two guidelines still leaves too many funds to evaluate in a reasonable amount of time. Additional guidelines need to be established, but the additional guidelines will not necessarily apply across the remaining universe of funds. For example, the guidelines for a merger arbitrage fund will differ from those for a long-short market-neutral fund.

To facilitate the investor’s search for high-quality funds that not only meet the initial return and risk guidelines but also meet strategy-specific guidelines, the next step is to establish a set of relative guidelines. Relative performance metrics should always be based on specific categories or strategies. For example, it would not be fair to compare a leveraged global macro fund with a market-neutral, long/short equity fund.

To establish guidelines for a specific strategy, an investor can use an analytical software package (such as Morningstar) to first identify a universe of funds using similar strategies. Then, a peer analysis will reveal many statistics, broken down into quartiles or deciles, for that universe.

The threshold for each guideline may be the result for each metric that meets or exceeds the 50th percentile. An investor can loosen the guidelines by using the 60th percentile or tighten the guideline by using the 40th percentile. Using the 50th percentile across all the metrics usually filters out all but a few hedge funds for additional consideration. In addition, establishing the guidelines this way allows for flexibility to adjust the guidelines as the economic environment may impact the absolute returns for some strategies.

Factors used by some advocates of hedge funds include:

• Five-year annualized returns

• Standard deviation

• Rolling standard deviation

• Months to recovery/maximum drawdown

• Downside deviation

These guidelines will help eliminate many of the funds in the universe and identify a workable number of funds for further analysis.

Generation-Skipping Trust Lets the Next Generation Avoid Estate Taxes

A generation-skipping trust (GST) is a legally binding agreement in which assets are passed down to the grantor’s grandchildren (skipping the children). A generation-skipping trust (GST) is a type of legally binding trust agreement in which the contributed assets are passed down to the grantor’s grandchildren, thus “skipping” the next generation, the grantor’s children. By passing over the grantor’s children, the assets avoid the estate taxes—taxes on an individual’s property upon his or her death—that would apply if the children directly inherited them.

Generation-skipping trusts are effective wealth-preservation tools for individuals with significant assets and savings.

KEY TAKEAWAYS

• A generation-skipping trust (GST) is a legally binding agreement in which assets are passed down to the grantor’s grandchildren—or anyone at least 37½ years younger—bypassing the next generation of the grantor’s children.

• By skipping the opportunity to receive the assets, the children of the grantor avoid the estate taxes that would otherwise be due.

• Generation-skipping trusts are liable for taxation if the amount transferred exceeds a certain annually adjusted threshold ($11.58 million in 2020).
  

Because a generation-skipping trust effectively transfers assets from the grantor’s estate to grandchildren, the grantor‘s children never take title to the assets. This is what allows the grantor to avoid the estate taxes that would apply if the assets came into the possession of the next generation first.

Though grandchildren are the most common beneficiaries, the recipient of a generation-skipping transfer doesn’t necessarily have to be a family member. The beneficiary can be anybody who is at least 37½ years younger than the grantor and not a spouse or ex-spouse.

Generation-skipping trusts can still provide some financial benefits to the next generation because the grantor can give children access to any income the trust’s assets generate while still leaving the assets themselves in trust for grandchildren.

Due to the generation-skipping trust’s viability as a loophole to avoid federal estate taxes, changes were made to the tax code in 1986 that created a generation-skipping transfer tax. Generation-skipping transfer tax rates have risen and fallen over the years, with a recent high of 55% in 2001 and a low of 0% in 2010—due to an exemption awarded by the 2010 Tax Relief Act.

Intended to ensure that people transferring modest sums of wealth to younger generations don’t have to bear the brunt of the tax burden, these exemptions were secured by the American Taxpayer Relief Act of 2012. This legislation established a permanent $5 million tax exemption on generation-skipping transfers, which meant the federal tax on a generation-skipping transfer of wealth would apply only if the amount exceeded $5 million. This amount adjusts annually to account for inflation. For example, it increased from $5.45 million in 2016 to $5.49 million in 2017.

The generation-skipping tax exemption amount for 2020

Increasing the Generation-Skipping Trust Tax Exemption

Even with the installment of taxes on generation-skipping transfers, GSTs still serve as tools for high-net-worth individuals to transfer wealth at a lower tax rate. And they became even sharper tools on Dec. 22, 2017, when President Donald Trump signed into effect the Tax Cuts and Jobs Act, which doubled the generation-skipping tax exemption.

Starting on Jan. 1, 2018, the Tax Cuts and Jobs Act (TCJA) doubled the estate tax exemption to $11.2 million for singles and $22.4 million for married couples, but only for 2018 through 2025. The exemption level is indexed for inflation. The 40 percent top tax rate remains in place.



This act expires on Jan 1, 2026, pushing the exemptions back to their pre-Act amounts unless Congress extends them.

A dynasty trust is a long-term trust created to pass wealth from generation to generation without incurring estate taxes. dynasty trust is a long-term trust created to pass wealth from generation to generation without incurring transfer taxes, such as the gift tax, estate tax, or generation-skipping transfer tax (GSTT), for as long as assets remain in the trust.

The dynasty trust’s defining characteristic is its duration. If it’s properly designed, it can last for many generations, possibly forever.

A dynasty trust that’s established in the right state can theoretically last forever.

Historically, trusts could only last for a certain number of years. Many states had a “rule against perpetuities” and stipulated when a trust had to come to an end. A common rule was that a trust could continue for 21 years after the death of the last beneficiary who was alive when the trust was established. Under those circumstances, a trust could theoretically last for 100 years or so. Some states, however, have done away with their rules against perpetuities, making it possible for wealthy individuals to create dynasty trusts that can endure for many generations into the future.

The immediate beneficiaries of a dynasty trust are usually the children of the grantor (the person whose assets are used to create the trust). After the death of the last child, the grantor’s grandchildren or great-grandchildren generally become the beneficiaries. The trust’s operation is controlled by a trustee who is appointed by the grantor. The trustee is typically a bank or other financial institution.

KEY TAKEAWAYS

• Dynasty trusts allow wealthy individuals to leave money to future generations, without incurring estate taxes.

• Under current law, an individual can put up to $11.4 million in a dynasty trust.

• Dynasty trusts are irrevocable and their terms can’t be changed once they’re funded.

A dynasty trust is a type of irrevocable trust. Grantors can set strict (or lax) rules for how the money is to be managed and distributed to beneficiaries. But once the trust is funded, the grantor will not have any control over the assets or be permitted to amend the trust’s terms. The same is true for the trust’s future beneficiaries.

Assets that are transferred to a dynasty trust can be subject to gift, estate, and GSTT taxes only when the transfer is made and only if the assets exceed federal tax exemptions. As a result of the Tax Cuts and Jobs Act of 2017, the federal estate tax exemption is $11.58 million for 2020 and the amount will be adjusted annually for inflation. Of course, Congress could also raise or lower the estate tax exemption in future years or do away with the estate tax entirely.

So, for now, an individual can put $11.4 million in a dynasty trust for his or her children or grandchildren (and, in effect, their children and grandchildren) without incurring these taxes. Moreover, the assets that go into a dynasty trust, as well as any appreciation on those assets, are permanently removed from the grantor’s taxable estate, providing another layer of tax relief.

A trustee can distribute money from the trust to support beneficiaries as outlined in the trust terms. But because beneficiaries lack control over the trust’s assets, its protected from claims by a beneficiary’s creditors because the assets belong to the trust, not to the beneficiary.

However, income tax will still apply to a dynasty trust. To minimize the income tax burden, individuals often transfer assets to dynasty trusts that don’t produce taxable income, such as non-dividend paying stocks and tax-free municipal bonds.