MLPs and royalty trusts are little-known options for current income.

For several years many advisors have been searching for higher-yielding investments, and some have turned to master limited partnerships (MLPs) and royalty trusts for that very reason.

Many of these investments are offering annual yields of 8%, 9% and even 15%. Considering that numerous market observers are predicting single-digit returns for traditional equities for several years to come, the distributions flowing from MLPs and royalty trusts look enticing, to say the least. Also, interest in investments that offer current income is expected to grow as more baby boomers reach retirement age.

But are MLPs or royalty trusts right for your clients? Maybe for some of them. The investments have similarities, but also major differences.

Like fixed-income investments, MLPs and royalty trusts trade based on their current yield. Although they may offer a steady income stream, their distributions and unit prices can fluctuate.

Both are publicly traded and owned primarily by individual investors. Most mutual funds stay away from them because the U.S. tax code limits the amount of income that they can get from such sources. Some investors shy away because their structure is more complex than that of corporate stock. And some people may hesitate to invest because they remember the highly publicized partnership losses in the 1980s.

"Partnerships got a bad rap in the '80s and deservedly so for some of them," says Mary Lyman, general counsel for the Coalition of Publicly Traded Partnerships, an MLP trade group. "The problems were not so much with publicly traded partnerships but with the tax-shelter ones designed to throw off losses. They didn't have a lot of economic substance, and the IRS cracked down on them pretty heavily. A lot of investors in the tax-shelter partnerships had a lot of losses they couldn't deduct. There were a lot of oil and gas and real estate partnerships that didn't do too well." With the ones that weren't publicly traded, investors had a hard time getting out, she adds.

Today, royalty trusts and the majority of MLPs get their cash flow from businesses in the energy industry. Both can be structured to pass through their available cash flow to investors and avoid the double taxation imposed on corporate dividends. Distributions are a combination of net income and what is basically a return of capital. The return of capital, actually an allowance for depletion or depreciation, decreases an investor's basis, and taxes are deferred on that portion of the distribution until the units are sold. As a result, tax filings for both are more complicated than they are for corporate stock.

One difference between the two investments is that cash flowing into royalty trusts primarily comes from oil and gas exploration, while cash going into energy-related MLPs usually comes from energy processing and distribution.

In most cases, royalty trusts aren't partnerships and all units are equal. Not so with MLPs, which have a general partner that operates the partnership, usually has about a 2% general partnership interest and owns common limited partnership units as well. As an MLP increases its distributions to common unitholders, the general partner usually gets a disproportionately higher amount of total distributions as an incentive. Some observers think these incentives are appropriate; others do not.

Since they trade based on their current yield, rising interest rates can negatively affect MLPs and royalty trusts. However, they generally have more impact on the unit prices of MLPs, whose fees, based on contracts, won't necessarily be rising at the same time. Royalty trust units often are less affected because inflation generally accompanies interest-rate hikes, and that means the prices they get for their oil and gas will rise, too.

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