An MLP is a master limited partnership, but the title isn’t as interesting as what it can accomplish from an investing standpoint.

MLPs are publicly traded partnerships that are listed on major exchanges such as the NYSE or Nasdaq. To qualify as MLP, it must earn 90% of its income from minerals and natural resources—namely from exploration, development, mining or production, processing, refining, transportation and marketing. It may also earn certain passive income from interest, dividends and property rent.

What’s most intriguing about MLPs is the unique business structure and tax advantages the partnership offers. MLPs are set up by their partnership agreements to distribute the majority of their cash flow to shareholders, officially called unitholders. This cash flow is what makes MLPs attractive to investors. Most partnerships forecast what they expect to distribute in cash over the next 12 months, which offers some level of predictability for unitholders.

One consequence of the MLP's unique structure is the partnership doesn’t pay taxes at the company level. There are tax benefits for unitholders as well. Because the MLP is able to claim a variety of deductions, the partnership's taxable income is often lower than the paid-out cash flows. This means cash flow received by the unitholder is treated as return on capital, and therefore is tax-deferred (though not tax free).

Tax Implications of MLPs

As a unitholder of an MLP, you’re providing capital to the venture and being rewarded with cash distributions from ongoing operations. This makes MLPs a good option to consider for retirees or anyone else looking for a consistent income stream.

Since distributions are a return on capital, they are mostly tax-deferred. But when you sell, you will pay taxes based on the difference between the sales price and your adjusted basis. For example, you purchase $100,000 worth of MLP units, you receive $4,000 in distributions and there is $3,000 in unit depreciation. You only have to pay taxes on the difference: $1,000. This is on the federal and state level.

While the distributions are nice, the return of capital has the effect of lowering your cost basis. If you hold for long enough, your basis could eventually reach zero. Once that happens, any future distributions are treated as capital gains in the year in which they are received.

The sale of an MLP could result in both a capital gain and ordinary income for the investor. Because the cash distributions are due to depreciation and other deductions that the MLP takes, those deductions are recaptured upon the sale of the units and are taxed as ordinary income. Any appreciation of the value of the units is taxed as a capital gain. Investors will need to keep track of their K-1 schedules to figure out how much is capital gain and how much is ordinary income.

Fortunately, there’s a loophole. If you use your MLP for estate planning, then you will receive a mostly tax-deferred income stream while also avoiding a big tax hit on a sale of your MLP units.

Here’s how it works. As long as you don't cash out of the MLP, but bequeath it to a spouse or the next generation (via a will, living trust or just transfer on death account), you won’t have to pay taxes on a very low-cost basis (which will stem from the MLP being held for a long period of time). Better yet, your heir will inherit the MLP at a higher cost basis, which gets readjusted to the market price on the date of the transfer. This is know as a step-up in basis. And if your heir wants to sell the MLP right away, there will be no capital gains tax.

All good news so far, but as you already know, there’s no such thing as a perfect investment. MLPs, like anything else, have their drawbacks.

Drawbacks of MLPs

Ordinary dividends require to be filed on a Form 1099-DIV, but distributions from an MLP must be filed via Form K-1. This is much more complicated. That being the case, your accountant will charge you more for the work he/she has to do. This may just be a few hundred dollars, but depending on the size of your investment in an MLP, this can add up, since it must be done on an annual basis.

Another negative here is that many MLPs operate in more than one state. This means you will have to file in several different states. Fortunately, the state where you will find a lot of MLP opportunities does not have a state income tax — Texas. This is also true of Alaska, Wyoming, Nevada, Tennessee and South Dakota, where many MLPs operate. Florida, Washington and New Hampshire also lack a state income tax.

This isn’t the only disadvantage of investing in an MLP. You might be thinking that a net loss from the MLP units can offset your other income, but no. Any losses must be carried forward and used against future income from the same MLP. If the losses continue, then you can’t deduct those losses against other income until you sell your units in the MLP.

Popular MLP Investments

Overall, the positives outweigh the negatives for an MLP. This doesn’t guarantee success by any means, but thanks to tax advantages, it’s an investment vehicle to consider. For starters, here are some popular MLP investments on Wall Street:

  • Enterprise Products Partners (EPD)
  • Plains All American Pipeline (PAA)
  • Dominion Energy (D)
  • EQM Midstream Partners (EQM)

If you would prefer to keep things simple while being diversified, consider an MLP exchange-traded fund (ETF) such as Alerian MLP ETF (AMLP). The ETF has exposure to twenty MLP companies, including Energy Transfer LP (ET), MPLX LP (MPLX), and Magellan Midstream Partners LP (MMP).

The Bottom Line

MLPs offer a cost advantage over regular company stocks since they’re not hit with a double tax on dividends. In fact, their cash distributions are not taxed at all when unitholders receive them, which is very appealing. However, the longer an MLP is held, the more likely the cost basis will decrease, which increases the tax obligation after units are sold. One solution is to bequeath the MLP to your survivors as part of your estate. But even if you don’t take that route, the cash distributions for an MLP usually outweigh taxable income, anyway.

Dan Moskowitz does not own shares in any MLPs or MLP ETFs.