What Is a Master Limited Partnership (MLP)?
Master limited partnerships (MLPs) are a business venture that exists in the form of a publicly traded limited partnership. They combine the tax benefits of a private partnership—profits are taxed only when investors receive distributions—with the liquidity of a publicly-traded company (PTP).
A master limited partnership trades on national exchanges. MLPs are situated to take advantage of cash flow, as they are required to distribute all available cash to investors. They can also help reduce the cost of capital in capital-intensive businesses, such as the energy sector.
The first MLP was organized in 1981. However, by 1987, Congress effectively limited the use of them to the real estate and natural resources sectors. These limitations were put into place out of a concern over too much lost corporate tax revenue since MLPs do not pay federal income taxes.
Master Limited Partnership (MLP)
Understanding a Master Limited Partnership
The MLP is a unique hybrid legal structure that combines elements of a partnership with elements of a corporation. First of all, it is considered the aggregate of its partners rather than a separate legal entity—as is the case with a corporation. Second, it technically has no employees. The general partners are responsible for providing all necessary operational services. General partners usually hold a 2% stake in the venture and have the option to increase their ownership.
Like a partnership, an MLP issues units instead of shares. However, these units are often traded on national stock exchanges. The availability of exchanges offers significant liquidity that traditional partnerships do not offer. Because these publicly traded units are not stock shares, those who invest in MLPs are commonly referred to as unitholders, rather than shareholders. Those who buy into an MLP are also called limited partners. These unitholders are allocated a share of the MLP's income, deductions, losses, and credits.
MLPs have two classes of partners:
- Limited partners are investors who purchase shares in the MLP and provide the capital for the entity's operations. They receive periodic distributions from the MLP, typically every quarter. Limited partners are also known as silent partners.
- General partners are the owners who are responsible for managing the day-to-day operations of the MLP. They receive compensation based on the partnership's business performance.
- A master limited partnership (MLP) is a company organized as a publicly traded partnership.
- MLPs combine a private partnership's tax advantages with a stock's liquidity.
- MLPs have two types of partners, the general—managers—and the limited—investors.
- Investors receive tax-sheltered distributions from the MLP.
- MLPs are considered low-risk, long-term investments, providing a slow but steady income stream.
- MLPs are limited to the natural resources and real estate sectors.
Tax Treatment of Master Limited Partnerships
An MLP is treated as a limited partnership for tax purposes. A limited partnership has a pass-through, or flow-through, tax structure. This taxing method means that all profits and losses are passed through to the limited partners. In other words, the MLP itself is not liable for corporate taxes on its revenues, as most incorporated businesses are. Instead, the owners—or unitholder investors—are only personally liable for income taxes on their portions of the MLP's earnings.
This tax scheme offers a significant tax advantage to the MLP. Profits are not subject to double taxation from corporate and unitholder income taxes. Standard corporations pay corporate tax, and then shareholders must also pay personal taxes on the income from their holdings. Further, deductions such as depreciation and depletion also pass through to the limited partners. Limited partners can use these deductions to reduce their taxable income.
To maintain its pass-through status, at least 90% of the MLP's income must be qualifying income. Qualifying income includes income realized from the exploration, production, or transportation of natural resources or real estate. In other words, to qualify as a master limited partnership, a company must have all but 10% of its revenues be from commodities, natural resources, or real estate activities. This definition of qualifying income reduces the sectors in which MLPs can operate.
Quarterly distributions from the MLP are not unlike quarterly stock dividends. But they are treated as a return of capital (ROC), as opposed to dividend income. So, the unitholder does not pay income tax on the returns. Most of the earnings are tax-deferred until the unitholder sells their portion. Then, the earnings receive the lower capital gains tax rate rather than at the higher personal income rate. This categorization offers significant additional tax benefits.
Advantages and Disadvantages of MLPs
Like any investment, MLPs have their pros and cons. MLPs may not work for all investors. Also, an investor must offset the disadvantages against any benefits of holding units of MLPs before they invest.
Upsides of MLPs
MLPs are known for offering slow investment opportunities. The slow returns stem from the fact that MLPs are often in slow-growing industries, like pipeline construction. This slow and steady growth means MLPs are low risk. They earn a stable income often based on long-term service contracts. MLPs offer steady cash flows and consistent cash distributions.
The cash distributions of master limited partnership usually grow slightly faster than inflation. For limited partners, 80%-90% of the distributions are often tax-deferred. Overall, this lets MLPs offer attractive income yields—often substantially higher than the average dividend yield of equities. Also, with the flow-through entity status and by avoiding double taxation, it leads to more capital being available for future projects. The availability of capital keeps the MLP firm competitive in its industry.
Further, for the limited partner, cumulative cash distributions usually exceed the capital gains taxes assessed once all units are sold.
There are benefits for using MLPs for estate planning, as well. When unitholders gift or transfer the MLP units to beneficiaries, both will avoid paying taxes during the time of transfer. The cost basis will readjust based on the market price during the time of the transfer. Should the unitholder die and the investment pass to heirs, their fair market value is determined to be the value as of the date of death. Also, earlier distributions are not taxed.
Limited to two industries
Downsides of MLPs
Perhaps the biggest hassle to being an MLP limited partner is that you will have to file the infamous Internal Revenue Service (IRS) Schedule K-1 form. The K-1 is a complicated form and may require the services of an accountant—even if you did not sell any units. Also, K-1 forms are notorious for arriving late, after many tax preparers thought they had completed their taxes. Also, as an added problem, some MLPs operate in multiple states. Income received may require state tax returns filed in several states, which will increase your costs.
Another tax-related negative is that you cannot use a net loss—more losses than profits—to offset other income. However, net losses may carry forward to the following year. When you eventually sell all your units, a net loss can then be used as a deduction against other income.
A final negative is limited upside potential—historically—but this is to be expected from an investment that is going to produce a gradual yet reliable income stream over several years.
Real-World Examples of Master Limited Partnerships
Most MLPs currently operate in the energy industry. An energy master limited partnership (EMLP) will typically provide and manage resources for other existing energy-based businesses. Examples might include firms that provide pipeline transportation, refinery services, and supply and logistics support services for oil companies.
Many oil and gas firms will issue MLPs instead of shares of stock. With this structure, they can both raise capital from investors while still maintaining a stake in operations. Some corporations may own a sizable interest in its MLPs. Separate stock-issuing companies are also set up, with their sole interest being to own units of the corporate's MLP. This structure allows redistributing the passive income through the corporation as a regular dividend.
A good example of this structure was Linn Energy Inc., which had both an MLP (LINE) and a corporation that owned an interest in the MLP (LNCO). Investors had the option to choose—for tax purposes—how they would like to receive the income the company generated.
The firm was dissolved in 2017 after filing for bankruptcy in 2016. It was reorganized in 2018 as two new companies Riviera Resources and Roan Resources. Investors in LINE were given an exchange offer, to convert their units into shares of the new entities.