Generally, a partnership is a business that is owned by two or more individuals. In all forms of partnerships, each partner is required to contribute resources such as property, money, skill or labor in exchange for sharing in the profits and losses of the business.
For limited partnerships and master limited partnerships, the simplest way to explain the difference between the two business structures is that the latter is publicly traded while offering the tax benefits of a limited partnership.
What Is a Limited Partnership?
A limited partnership features at least one general partner and at least one limited partner. The general partner acts as the owner and is responsible for day-to-day operations. They are also personally liable for the business’s debts. In other words, if the business becomes over-leveraged and can’t meet its debt obligations, then the general partner might be forced to sell personal assets.
Meanwhile, a limited partner only invests money in the business. They have no say in day-to-day operations, and are not personally liable for the business’s debts. A limited partner is also not susceptible to litigation. The only potential loss relates to the investment in the partnership. However, if a limited partner begins to take an active role in the business, that partner can become personally liable to both debt and litigation.
Since a limited partner is not active in the day-to-day operations of the business, that partner does not have to pay a self-employment tax. It is not considered earned income. In a limited partnership, the limited partners are essentially trading their role in day-to-day operations for not having to worry about being liable for the business’s debts or litigation.
What Is a Master Limited Partnership?
A master limited partnership (MLP) is a type of business venture that exists in the form of a publicly-traded limited partnership. With a master limited partnership, limited partners still get the tax advantage and they are not liable, but these advantages are now combined with liquidity since MLPs are traded like equities.
An MLP must generate 90 percent of its revenue from natural resources. This can pertain to energy pipelines, energy storage, commodities, or real estate. The quarterly distributions to limited partners stem from cash flow. This is a positive because cash flow is seen as steady.
For example, most MLPs have locked into long-term contracts and have hedged prices. Historically, this has led to lower volatility than their peers. Additionally, since income is passed on to unit holders (limited partners), an MLP avoids double taxation. This saves capital, which can then be applied to day-to-day operations and future projects.
The word "master" in MLPs pertains to the general partner, who will usually own two percent of the MLP. The master partner can increase their share by purchasing additional units as a limited partner. The master partner is also responsible for day-to-day operations. The general partner has a performance incentive because if quarterly cash distributions rise, then the general partner will receive a greater share. Those quarterly cash distributions, by the way, are 80-90 percent tax deferred thanks to depreciation.
MLPs usually yield between five and seven percent. When you combine this factor with low volatility and a tax advantage, MLPs look appealing. Furthermore, when a limited partner eventually sells all of their shares, it will be treated as capital gains, not ordinary income.
One negative aspect is that most MLP investors are investing in pipelines, and many pipelines stretch across more than one state. This means you will have to pay taxes in multiple states. Check with your tax advisor because certain states offer exemptions.
The Bottom Line
While there are advantages to investing in a limited partnership, investing in a MLP adds liquidity. Therefore, if you ever need to free up capital for an emergency or an unexpected project, you will be able to do so with ease trading an MLP.