There are significant tax benefits to owning units in a master limited partnership (MLP), although most investors do not want to hold an MLP interest in an individual retirement account (IRA). Distributions from MLPs to unit holders receive favorable tax treatment under the IRS code. An MLP is a pass-through entity, and partnership income is only taxed at the level of the partner. Distributions are not taxed when they are received, unlike dividends, which are taxed the year they are realized. Instead, the distributions are considered a reduction in the cost basis in the investment in the MLP. The tax liability from the distributions is only realized when the interest in the MLP is sold, and is thus deferred.
An MLP is a hybrid between a partnership and a publicly traded company. Most MLPs operate in the energy sector. Congress limited the use of MLPs to entities operating in certain sectors in 1987, including those operating businesses associated with natural resources. MLPs issue units, as opposed to shares, like companies do. An investor who buys units in an MLP is a limited partner in the business. The business on the MLP is operated by the general partner.
MLPs still offer significant liquidity, since an investor may buy units on national stock exchanges. Income from an MLP is not taxed at the corporate level, which avoids the common problem of double taxation for corporations. Many MLPs operate capital-intensive businesses, such as oil and gas pipeline and storage facilities. An investor in an MLP receives a K-1 schedule from the MLP stating the investor's portion of the MLP's net income. The income from an MLP is not tax-deferred if the units are held in an IRA, eliminating the tax benefits of an MLP investment.