A master limited partnership (MLP) is an unusual investment that combines the tax benefits of a limited partnership (LP) with the liquidity of a common stock. It is organized as a publicly traded partnership (PTP), a type of LP where the limited partners’ shares are freely traded on securities exchanges. Thus, while an MLP has a partnership structure, it issues shares that trade on an exchange like common stock.

Today’s MLPs are defined by the 澳洲幸运5官方开奖结果体彩网:Tax Reform Act of 1986 and the Revenue Act of 1987, which outline how companies can structure their operations to realize certain tax benefits and define which companies are eligible. To qualify, a firm must earn 90% of its income through activities or interest and dividend payments relating to natural resources, energy, commodities, or real estate. If a company does qualify, an MLP can provide it with a variety of benefits.

Tax Benefits

Tax implications for MLPs differ significantly from those for corporations for both the company and its investors. Like other LPs, there is no tax at the company level. This essentially lowers an MLP’s 澳洲幸运5官方开奖结果体彩网:cost of capital, as it does not suffer the problem of 澳洲幸运5官方开奖结果体彩网:double taxation on dividends. Companies that are eligible to become MLPs have a strong incentive to do so ᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚbecause it provides a cost advantage over their incorporated peers.

In an MLP, instead of paying a corporate income tax, the tax liability of the entity is passed on to its unitholders. Once a year each investor receives a K-1 statement (similar to a 1099-DIV form) detailing their share of the partnership’s net income, which is then taxed at the investor’s individual tax rate.

One important distinction must be made here: While the MLP’s income is passed through to its investors for tax purposes, the actual cash distributions made to unitholders have little to do with the firm’s income. Instead, cash distributions are based on the MLP’s distributable cash flow (DCF), which is similar to 澳洲幸运5官方开奖结果体彩网:free cash flow (FCF). Unlike dividends, these distributions are not taxed when they are received. Instead, they are considered reductions in the investment’s 澳洲幸运5官方开奖结果体彩网:cost basis anཧd create a tax liability that is deferred uᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚntil the MLP is sold.

Fortunately for investors, MLPs generally have much higher distributable cash flow than they have 澳洲幸运5官方开奖结果体彩网:taxable income. This is a result of significant depreciation and other 澳洲幸运5官方开奖结果体彩网:tax deductions and is especially true of natural gas a🐈nd oil🔯 pipeline and storage companies, which are the most common businesses to choose an MLP structure.

Investors then receive higher cash payments than the amount upon which they are taxed, creating an efficient means of tax deferral. The taxable income passed on to investors often is only 10% to 20% of the cash distribution, while the other 80% to 90% is deemed a 澳洲幸运5官方开奖结果体彩网:return of capital and subtracted from the original cost basis of the initial investment.

MLP Cash Flows and Taxes

Let’s look at an example of the mechanics of cash flows and taxes that occur when holding and selling MLPs. Assume that an MLP is purchased for $25 per share, held for three years, makes cash distribu🍸tions of $1.50 per unit per year, and passes through $0.30 of taxable income to each unit per year.

First, calculate the change in cost basis caused by the net return of capital—cash distributions minus allocation of taxable income—over the life of the investment. For simplicity, assume taxable income and cash distribution remain constant through the life of the investme🍰nt, although in reality these probably would fluctuate each year.

If the MLP is sold at the end of the third year for $26 per unit, the investor would show a gain of $4.60. One dollar of this would be a normal capital gain—having bought at $25 and sold at $26—and would be taxed at the long-term 澳洲幸运5官方开奖结果体彩网:capital gains tax rate. The remaining $3.60 gain results from the $1.20 return of capital each year, and this amount would be taxed at𝕴 the investor’s personal income tax rate. The table below shows cash flows, including those re❀lated to taxes, during the life of the investment. We assume a 35% income tax rate and a 15% capital gains rate.

An important side note on the concept of reducing cost basis: If and when the investment’s cost basis falls to zero, any cash distribution becomes immediately taxable, rather than being deferred until the sale of the security. This is because the investment cannot fall into a negative cost basis. This can occur if an MLP is held for many years.

MLPs can be used to gain current income while deferring taxes, as seen in the above example. This can be taken one step further when an MLP investment is used as a vehicle for 澳洲幸运5官方开奖结果体彩网:estate planning. When an MLP unitholder dies and the investment is transferred to an heir, the cost basis is reset to the market price on the transfer date, eliminating any accrued tax liability caused by a return of capital.

Diversification Benefits

Investors can benefit by investing in MLPs, as they are not highly correlated with other asset classes, including stocks, bonds, and commodities. Additionally, they have a correlation coefficient of less than 0.5 to both 澳洲幸运5官方开奖结果体彩网:real estate investment 🅺trus🌜ts (REITs) and the S&P 500. This makes them good diversifiers.

澳洲幸运5官方开奖结果体彩网:Diversification is a widely used investment strategy to smooth out unsystematic risk events in a portfolio without sacrificing expected returns. It is intended to allow the positive performance of some investments to neutralize the 澳洲幸运5官方开奖结果体彩网:negative performance of others. Diversification is only successful if the securities in the portfolio are not perfectly 澳洲幸运5官方开奖结果体彩网:correlated. 𒅌That is, they respond differently, often in opposing ways, to market influences.

Moreover, an investor interested in buying MLPs could consider investing in a portfolio of MLPs that is itself diversified across sectors to further reduce risk. For example, one 🦄could look to MLPs in the real estatཧe, infrastructure, and renewable energy sectors.

Higher Yields

MLPs are known for offe🍰ring relatively slow investment returns th♛at stem from the fact that they are often established in capital-intensive and slow-growing industries, such as pipeline construction. This slow but steady growth means MLPs generate a stable income based on long-term service contracts and consistent cash distributions to investors.

The cash distributions of MLPs usually grow slightly faster than inflation. For limited partners, 80% to 90% of the distributions are often tax deferred. Overall, this lets MLPs offer attractive income yields that are oft🍷en substantially higher than the average dividend yield of equities. Also, with the flow-through entity status (and avoiding double taxation), more capital is available for future🅰 projects. The availability of capital keeps the MLP firm competitive in its industry. 

MLP Partnership Structure

MLPs contain two business entities: the 澳洲幸运5官方开奖结果体彩网:limited partners and the 澳洲幸运5官方开奖结果体彩网:general partner. The former invests capital into the venture and obtain periodic cash distributions, while the latter oversees the MLP’s operations and receives 澳洲幸运5官方🥀开奖结果体彩网:incentive distributions rights (IDRs). IDRs are structured when the partnership is formed and provide the general partner with performance-based pay for successfully managing the MLP, as measured by cash distributions to the limited partners.

The general partner usually receives a minimum of 2% of the LP distribution. However, as payment to LP unitholders increases, so does the percentage take of the general partner through IDRs, often to a maximum of 50%. The table bel🐽ow shows a hypothetical IDR structure outlining the payment split between limited partners and the general partner at different distribution levels.

For each incremental dollar distributed to limited partners, the general partner realizes higher marginal IDR payments. For example, assuming 1𝔍,000 LP units outstanding, if $1,000 is distributed to limited partners ($1.00 per unit), then the general partner will receive $20 (2% of $1,000). However, if $5,000 is distributed to limited partners ($5.00 per unit), then the general partner will receive $2,810, as outlined below.

Here we see that the general partner has a significant financial incentive to increase cash distributions to limited partner unitholders; while distribution to limited partners increases by 500%, from $1,000 to $5,000, distribution to the general partner increases by more than 14,000%, rising from $20 to $2,820. Note in the calculations in the above table that the IDR payment is not a percentage of the incremental limited partners distribution amount, but rather a percentage of the total amount distributed at the marginal level. For example, in the third tier, $1.54 is distributed per LP unit; $1.00 (65%) of that amount is paid to limited partners and $0.54 (35%) is paid to the general paജrtner.

The corporate structure of MLPs can be more complex than a simple split between limited and general partnership interests. In some cases, the general partner may own LP shares. In other cases, the general partnership of an MLP may be 澳洲幸运5官方开奖结果体彩网:publicly traded, and have its own limited partner/general partner split. The MLP may have other relationships with additional entities due to financing arrangements. However, the mo🐓st important relationship for the MLP investor to keep in mind is the cash distribution split between limited partners and the general partner and how this will changeꦜ over time as distributions fluctuate.

Should You Own MLPs?

MLPs have remained relatively unknown in part because of their low level of 澳洲幸运5官方开奖结果体彩网:institutional ownership and a consequent lack of 澳洲幸运5官方开奖结果体彩网:sell-side attention. Mutual funds were largely restricted from owning MLPs until 2004, but even now MLPs present a cumbersome investment. This is because funds must send out 1099 forms to their investors detailing income and capital gains in November but may not receive K-1 statements from MLPs until Feꦛbruary. This leads to the potential for costly mistakes in estimation.

Tax-exempt institutional investment funds, such as pensions, endowments, and 401(k) plans, are restricted from owning MLPs, because the cash distributions received are considered 澳洲幸运5官方开奖结果体彩网:unrela💦ted business taxable income (UBTI)—income that is unrelated to the activity that gives the fund tax-exempt status. This could create a tax liability on any distribution of more than $1,000. This is also true for individuals when holding MLPꦯs in an individual retirement account ღ(IRA); therefore, the best way to hold them is in a regular brokerage account.

Individual investors are the principal owners of MLPs. Because few individuals know much about their🔴 structure and complex tax implications, they are often purchased for individuals by private-client wealth managers, although this need not be the case. As long as the individual or their accountant underst🍌ands how to manage the K-1 statement and cash distributions, this investment can be perfect for an investor seeking current income and tax deferral.

Downsides to MLPs

Though this article is titled "Benefits", let's quickly touch on the downsides of MLPs. One of the biggest concerns is market volatility. While MLPs primarily generate revenue from fee-based contracts, their unit prices can still be affected by fluctuations in the broader energy sector. If oil or natural gas prices decline significantly, investor sentiment toward MLPs may weaken, leading to price drops even if the underlying cash flows remain stable.

You should also think about regulatory and legislative risks. MLPs benefit from favorable tax treatment, but changes in tax laws or government policies could reduce or eliminate these advantages. If lawmakers decide to alter the tax structure that allows MLPs to avoid corporate taxation, their appeal to investors would likely go down as they wouldn't be quite as useful.

Another key risk is the potential for distribution cuts. If an MLP faces declining revenues due to lower demand, regulatory challenges, or rising debt costs, it may be forced to reduce or suspend distributions.ꦺ This means there might be a decline (and a quick decline) in unit prices. If credit markets tighten or borrowing costs rise, MLPs may struggle to fund new projects while maintaining their distributions.

Last, let's touch on interest rates. Interest rate risk is another important consideration. MLPs compete with other income-generating investments, such as bonds and dividend stocks. When interest rates rise, investors may shift their money into safer fixed-income assets, reducing demand for MLP units and pushing prices lower. Higher interest rates also increase borrowing costs for MLPs.

The Bottom Line

Master limited partnerships (MLP) combine the tax benefits of a limited partnership with the liquidity of a common 𝕴stock. To qualify to be an MLP, a firm has to earn 90% of its income through activities or interest and dividend payments related to natural resources, energy, commodities, or real꧒ estate.

Although these unusual investments are not well known, they can be attracti♚ve for individuals who are looking for current income and tax deferral.