What is a Master Limited Partnership (MLP)?

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Definition:

A master limited partnership (MLP) is a publicly traded company that has the tax benefits of a limited partnership.

🤔Understanding MLPs

A master limited partnership (MLP) is a public company with two different types of partners. The general partner handles the daily operations of the company. The limited partners invest in the company by purchasing shares (known as units). Limited partners don’t take an active role in management — They are silent partners. MLPs are taxed just like other limited partnerships, meaning profits or losses pass through to the owners. MLPs do not have to pay corporate taxes, but still get the benefits of being a publicly traded company, such as the ability to raise capital by selling stock. For a company to exist as an MLP, it must get 90 percent of its gross income each year from qualifying activities, such as producing or transporting minerals and natural resources.

Example

One of the biggest master limited partnerships (MLPs) in 2020 is Energy Transfer, which was worth about $22B as of April 2020. Founded in Texas in 1996, the energy company got its start with 200 miles of natural gas pipelines. Today the company owns more than 90,000 miles of pipelines that transport oil and gas across 38 states and also operates in China. Energy Transfer is an MLP, meaning it is taxed as a partnership but sells stock like a publicly traded company. Anyone can become a limited partner in Energy Transfer by purchasing units (shares) on the New York Stock Exchange.

Takeaway

A master limited partnership is like cross-breeding dogs…

When you cross-breed dogs, you often get the perks of two different breeds. But you might also create a slew of new complications. Similarly, MLPs allow companies to access many of the perks of both a limited partnership and a corporation, but they also come with complications and risks for investors.

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What is a master limited partnership?

A master limited partnership (MLP) is a business that acts as a hybrid between a traditional limited partnership and a public corporation — and enjoys some perks of both business structures.

Like limited partnerships, MLPs have two types of partners — A general partner runs the company, while limited partners provide capital. The general partner takes on personal liability for the business’s debts, but also gets decision-making power. Limited partners have limited liability, but don’t make the business decisions. Just like limited partnerships, MLPs generally don’t have to pay federal corporate taxes. Instead, profits pass through to the owners, who report their share of the income or losses on their individual tax returns.

Like a corporation, MLPs can sell stock to the general public, with shareholders becoming limited partners. This gives MLPs access to a bigger source of capital.

Under the federal Revenue Act of 1987, only certain types of companies can exist as MLPs. They must get 90 percent of their income from specific sources, mainly activities around mining and natural resources. The Emergency Economic Stabilization Act of 2008 expanded the acceptable income sources to include transportation of renewable and alternative fuels such as ethanol and biodiesel. Most MLPs are companies in the energy industry.

How does an MLP work?

As with other limited partnerships, master limited partnerships (MLPs) include two different types of partners. The general partner manages the company and gets a percentage of its income. A corporate sponsor that contributed start-up assets to the MLP usually controls the general partner and appoints the general partner’s board of directors. The MLP doesn’t have its own board of directors.

The other type of partner in an MLP is a limited partner. They get a cut of the profits, but aren’t involved in day-to-day operations of the company. Instead, they become owners in the company by purchasing units (shares) in the firm. While they aren’t liable for all of the company’s debts, they’re liable up to the amount of capital they put into the company. Unlike shareholders in other companies, limited partners often don’t get voting rights.

What are the features of MLPs?

Though every master limited partnership (MLP) might look a bit different, most of them tend to share a set of similar features:

  • A corporate sponsor
  • A general partner who is controlled by the corporate sponsor
  • Limited partners who invest in the MLP by purchasing units
  • Cash distributions to partners
  • A role in the energy sector
  • Special tax advantages, in that the profits and losses pass through to the owners rather than being subject to corporate taxes (double taxation)

How are MLPs taxed?

Like a typical partnership, sole proprietorship, or limited liability company (LLC), MLPs aren’t subject to double taxation. Double taxation is what most corporations experience: The firm pays corporate taxes on earnings, and then the owners pay income taxes when they receive the profits as dividends.

MLPs don’t pay corporate taxes. Instead, they pass all of their income, capital gains, deductions, and losses through to the owners. Then, the general partner and limited partners receive a Schedule K-1 form, which they use to file their tax returns. The partners have to claim their share of the profits of the company even if they didn’t actually receive distributions (or if their share of the distributions are lower than their share of the profits).

One unique feature of MLP taxation is that individual investors might have to file a tax return in the home state of the MLP, even if they don’t live there. In some cases, they might even have to file taxes in each state where the company does business. As with other investments, traders may face other tax consequences as well, such as capital gains taxes if they sell at a profit.

MLP investors generally only pay taxes on 10 to 20 percent of their cash distributions. That’s because MLPs usually have high depreciation and amortization costs that can offset their taxable income. While this sounds like a perk, investors will eventually have to pay taxes on those earnings when they sell the investment.

What are the advantages and disadvantages of MLPs?

Master limited partnerships (MLPs) are a hybrid of two different business structures, which comes with pros and cons.

Advantages:

  • MLPs don’t have to pay corporate taxes and instead can pass their profits and losses through to the owners.
  • MLPs have historically often been high-yield investment opportunities compared to stocks and bonds, partially as a result of the pass-through taxation (though past performance is not a guarantee of future results).
  • Because they’re listed on national exchanges, MLP units are easy to buy and sell, and therefore are highly liquid.
  • Because investors are limited partners, they aren’t liable for the debts and obligations of the company beyond the capital they contributed.
  • Being an MLP can be favorable to the company, as it can limit liability across different ventures in different states. Additionally, it might give companies more options when it comes to structuring debt financing.

Disadvantages:

  • Though the tax situation can be advantageous, it’s also complicated. Even units in a tax-advantaged retirement account might result in taxable income.
  • MLPs tend to be higher-risk investments as a result of interest rate sensitivity and higher volatility.
  • MLPs primarily exist in the energy infrastructure industry. As a result, these investments can be more sensitive to shifts in energy prices or to new energy legislation.
  • In some cases, investors might have to file taxes in each state where the MLP does business.
  • The governance features of MLPs can result in conflicts of interest and decisions being made in the favor of management rather than the investors.

What are some considerations when analyzing MLPs?

Master limited partnerships (MLPs) often have the potential to produce a higher yield than other investments for a few different reasons. The pass-through taxation that MLPs enjoy means that more of the company’s earnings are making it to the owners instead of a chunk coming out for taxes first.

But MLPs are a niche and higher-risk investment and may not be right for the average investor. They tend to be more volatile than other opportunities and more sensitive to interest rate fluctuations and regulatory changes. They also require figuring out some potentially complex tax issues.

Do MLPs pay dividends?

Investing in a master limited partnership (MLP) can be a lot different than investing in a run-of-the-mill corporation. MLP investors can still receive payments as a result of the shares they own, but those payments aren’t dividends. Instead, MLPs pay distributions to their investors.

The difference between dividends and distributions might seem like a technicality, but it matters when it comes to paying taxes and figuring out profitability. First, it’s not just the profits that pass through to the owners, as in the case of a corporation. Instead, deductions and credits also pass through to partners.

It’s important to note that not all of the money the investor gets from the company is a return on his or her investment. A significant chunk of the money investors get back is return of principal (aka return of capital), which is not a taxable event.

If you receive distributions from your investment in an MLP, you’ll receive a Schedule K-1 at the end of the year. This form contains all the information about the income, deductions, losses, and credits that passed from the company to you. The Schedule K-1 form is more complicated than the one you’d get if you received dividends. If you receive one of these forms, you may want to consult a tax accountant.

How are MLPs traded?

Master limited partnerships (MLPs) are publicly traded companies, which means that investors can buy stock in these companies. You can invest in an MLP by purchasing that company’s stock directly on an exchange. In return, you’ll usually receive distributions.

Rather than purchasing shares of a particular MLP, you can also invest in funds that include MLP shares. Doing so is a way of diversifying your portfolio and ensuring that your financial outcomes don’t rest on the success or failure of a particular company’s stock.

One option is to invest in MLP mutual funds. A mutual fund is an investment fund that includes a variety of different securities. Rather than investing in just one company, you’re investing in a bunch of companies at once. Some mutual funds specifically invest most of their assets into MLPs.

Another option for investing in MLPs is putting your money into exchange-traded funds (ETFs). ETFs are similar to mutual funds in that they invest their assets in a variety of different securities, but they can be traded like stocks. Like mutual funds, some ETFs specifically invest their assets in MLPs.

If you choose this route, you should always read about the investment objectives, risks and costs associated with the fund. These can be found in a fund’s prospectus available from your advisor or the fund company.

Diversification does not guarantee profit or prevent investment losses.

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