What is a master limited partnership (MLP) and how can it benefit investors?

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Master limited partnerships (MLPs) are a kind of limited partnership that is publicly traded. MLPs are a useful legal structure in a few industries such as energy, and they often pay big distributions, making them especially popular with income investors, though they do have some drawbacks.

Here’s how a master limited partnership works, examples of MLPs and their pros and cons.

What is an MLP and how does it work?

A master limited partnership offers the best features of a partnership with the liquidity of a publicly traded company. In a master limited partnership, a general partner (GP) manages the investments and conducts day-to-day affairs, while any number of limited partners (LPs) — the general investing public — can buy into the MLP and profit from ongoing operations.

For its efforts, the GP is paid management fees and often growing incentives as profits rise. Meanwhile, LPs enjoy the potential for capital gains and significant cash distributions. Because of its differing structure, shares of an MLP are called units — with owners often called unitholders — while payouts are called distributions (as opposed to dividends in a typical corporation).

MLPs benefit from the tax efficiency of the “pass-through” partnership structure, allowing them to pay attractive distributions to investors. MLPs are not subject to taxes, and instead can pass their earnings to partner-investors as a distribution. Those payouts are then taxable at the individual level, but only when the investor sells the stock, allowing investors to defer taxes.

To maintain the “pass-through” benefit, a company must earn 90 percent of its gross income each year from “qualifying” sources. Qualifying income is derived from activities such as the exploration and development of energy or other natural resources, the transportation of energy, dividends, gains from commodities and commodity futures and even rents from real estate. Qualifying income also includes gains on the sale of assets that generate qualifying income.

If a company cannot maintain its MLP status, then it is taxed at regular corporate rates.

Tax advantages of MLPs for investors

The MLP structure offers significant tax benefits to its investors, making it especially attractive:

• As a pass-through entity, the MLP pays no tax at the corporate level.
• The MLP structure avoids double taxation.
• Taxes on distributions are deferred until the units are sold.
• Distributions are ultimately taxed as capital gains at preferential rates.

Because of its pass-through structure, the MLP avoids the issue of double taxation that is typical of distributions from corporations. That is, corporations pay taxes when they generate a profit and then shareholders pay tax on any dividends they receive from the company. This greater tax efficiency makes the MLP a more attractive investment for some types of investors.

Unlike typical dividends — including tax-favored qualified dividends — MLP distributions are not taxed when they’re received. Instead, the distribution reduces the investor’s cost basis in the units. When the units are ultimately sold, then the income is treated as a capital gain and may enjoy much more favorable long-term capital gains tax rates. That said, if cumulative payouts take the investor’s cost basis to zero, then distributions are treated as a capital gain for that year.

Because MLPs are pass-through entities, the investor must pay taxes on a portion of the firm’s income based on their ownership percentage, even if they have not received a cash distribution. MLPs send a Schedule K-1 to investors after the tax year ends reporting their share of income.

Because of this deferred tax treatment and other tax issues, MLPs are not recommended in tax-advantaged accounts such as IRAs and 401(k)s. MLPs generate unrelated business taxable income (UBTI), which could jeopardize the tax advantages of these retirement accounts. Other tax laws make it inadvisable and cumbersome for non-U.S. citizens to invest in MLPs.

Publicly traded MLPs

Master limited partnerships are publicly traded, meaning anyone with a brokerage account and a little bit of money can buy into them.

They’re typically found in a few energy sub-industries:

• Exploration and production MLPs: These companies focus on finding and producing oil and gas, and are often called “upstream” due to where they sit in the supply chain.
• Gathering and processing MLPs: These businesses focus on moving natural gas from the site of production to a processing location, and are often called “midstream.”
• Transportation MLPs: These companies focus on moving energy products through pipelines, and may be “midstream” and/or “downstream.”
• Specialty MLPs: These companies may concentrate on more specialized energy areas such as coal, liquefied natural gas and propane.

Given the restrictions on what can count as qualifying income for MLP purposes, the types of businesses suitable for MLPs are fairly limited.

Pros and cons of MLPs

Pros of MLPs

• “Pass-through” legal structure: Its pass-through legal structure helps investors in MLPs avoid tax at the corporate level, with income and deductions being passed to the individual investor.
• High cash yields: MLPs are well known for their high cash payouts, making them especially attractive for income investors.
• Tax deferral on distributions: Tax on those cash payouts is not generated when they’re received but can be deferred until the investment is sold.
• Distributions treated at capital gains rates: When it’s time to pay taxes on the distributions, they’re treated at generally more favorable capital gains tax rates.
• Liability limited to the investment: The liability of MLP investors is limited to their total investment in the company, so they’re not subject to unlimited liability.

Cons of MLPs

• Complicated tax paperwork: The tax forms such as the K-1 can be complex, and it may be advisable to hire a tax professional to help you with filing your return correctly.
• Volatility: Energy-related investments are some of the more volatile investments, meaning that the units may fluctuate in price substantially.
• Not useful in tax-advantaged retirement accounts: MLPs are not useful in retirement accounts such as IRAs and 401(k)s, and may create further tax headaches.
• May be subject to state income taxes: MLPs that operate in more than one state may generate tax liabilities for the investor in multiple states, meaning the investor may have to file state tax returns in multiple states.

Bottom line

An MLP can be the right kind of investment for a certain kind of investor, especially one who can effectively use its tax-advantaged structure and its ability to pay sizable distributions. But the structure can also cause serious headaches due to the potential complexity of tax issues.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.