Master limited partnerships (MLPs) are a type of publicly traded limited partnership that is commonly utilized in industries such as energy. MLPs are popular among income investors due to their significant distributions, although they do come with certain drawbacks.
In this article, we will explore how master limited partnerships operate, provide examples of MLPs, and discuss their advantages and disadvantages.
Understanding MLPs and How They Work
Master limited partnerships combine the benefits of a partnership with the liquidity of a publicly traded company. In an MLP, a general partner manages the investments and day-to-day operations, while limited partners (the general investing public) can purchase units in the MLP to profit from its activities.
The general partner receives management fees and incentives based on profits, while limited partners have the opportunity for capital gains and substantial cash distributions. MLPs are tax-efficient due to their “pass-through” structure, allowing them to distribute earnings to investors without being subject to corporate taxes.
To maintain their tax benefits, MLPs must derive 90% of their income from qualifying sources, such as energy exploration and development, transportation, dividends, and real estate rents. If an MLP fails to meet these requirements, it may lose its favorable tax status.
The Tax Advantages of MLPs for Investors
Investing in MLPs offers several tax benefits:
- MLPs do not pay corporate taxes, as they are pass-through entities.
- Investors can defer taxes on distributions until they sell their units.
- Distributions are taxed as capital gains at preferential rates.
Unlike traditional dividends, MLP distributions are not taxed when received. Instead, they reduce the investor’s cost basis in the units, with taxation occurring when the units are sold. However, investing in MLPs in tax-advantaged accounts like IRAs and 401(k)s is not recommended due to tax implications.
Investing in Publicly Traded MLPs
Publicly traded MLPs are accessible to any investor with a brokerage account and capital. These MLPs are commonly found in energy sub-industries such as exploration and production, gathering and processing, transportation, and specialty energy areas.
Due to the restrictions on qualifying income for MLPs, the types of businesses suitable for this structure are limited.
The Pros and Cons of MLPs
Advantages of MLPs
- Pass-through legal structure that avoids corporate taxes.
- High cash yields, making MLPs attractive for income investors.
- Tax deferral on distributions until units are sold.
- Distributions taxed at capital gains rates.
- Investor liability limited to their investment.
Disadvantages of MLPs
- Complex tax paperwork, including K-1 forms.
- Volatility in energy-related investments.
- Not suitable for tax-advantaged retirement accounts.
- Potential state income tax liabilities for investors in multiple states.
Conclusion
Master limited partnerships can be a beneficial investment for certain investors, especially those who can leverage their tax advantages and high distributions. However, potential tax complexities and other drawbacks should be carefully considered before investing in MLPs.
Editorial Disclaimer: All investors should conduct thorough research into investment strategies before making decisions. Past performance is not indicative of future results.