A Master Limited Partnership (MLP) is a limited partnership listed on a securities exchange. This business structure allows the general partners to maintain complete control of the business, unlike a corporation that is answerable to shareholders. MLPs benefit from favorable tax treatment due to their status as a partnership, enabling them to avoid corporate income tax by passing through profits as distributions to the limited partners. To qualify for this favorable status, an MLP must derive at least 90% of its income from qualifying sources, primarily related to natural resources and infrastructure.
MLPs vs. Private Equity: MLPs resemble private equity investments with a General Partner (GP) and those that purchase the shares, known as Limited Partners (LPs). The GP oversees the operations of the partnership with a small ownership stake, typically around 2%. The LPs are passive investors with majority ownership and limited liability capped at their initial investment. To incentivize GPs to increase partnership distributions, many MLPs utilize Incentive Distribution Rights. This means that GPs receive a larger percentage of distributable cash flows as per-unit distributions rise, aligning their interests with increasing partnership profits.
Tax Advantages of MLPs: Due to this structure, LPs benefit from favorable tax treatment. Partnership profits, several deductions, and tax credits pass through to LPs, resulting in tax-deferred income for the majority of MLP earnings. As distributions are made, the tax-deferred portion reduces the investor’s cost basis. This deferred income remains untaxed until the investment is sold, then it is taxed at the capital gains rate if the cost basis remains positive. After the cost basis is reduced to zero, any additional deferred income is taxed as capital gains in the year in which they are received.
Additionally, all non-deferred gains are taxed as ordinary income, akin to ordinary non-qualified stock dividends. Because of this unusual tax treatment, MLP investors must file Form K-1 when paying taxes, as opposed to the standard Form 10993. LPs are also subject to state income taxes in each state in which the MLP operates, depending on the portion of the income derived from operations in each state, though this is often considered negligible under state minimums.
Risks of Investing in MLPs: While MLPs offer attractive tax advantages and high income relative to traditional equity investments, they come with potentially significant risks. They are often heavily exposed to sector-specific risks due to their focus on natural resources and infrastructure. Additionally, the high payout levels of MLPs make them subject to greater interest rate risk than ordinary equities.
Accessing MLPs and Tax Implications: Accessing MLPs through standard vehicles like mutual funds, ETFs, or notes does not pass on the tax benefits of holding individual MLPs. This means investors must either forgo diversification or manage the complexities of owning multiple individual MLPs, which can lead to challenges during tax season due to filing requirements. Additionally, holding MLPs in IRAs may trigger unrelated business income tax (UBIT), potentially requiring investors to file IRS Form 990T. Prospective MLP investors should carefully consider their investment rationale and preferred access method before committing capital.
Key Takeaways:
- Master Limited Partnerships (MLPs) offer unique tax benefits by passing through profits to limited partners.
- MLPs must derive 90% of their income from qualifying sources to maintain favorable tax status.
- Limited Partners (LPs) in MLPs enjoy tax-deferred income, reducing their cost basis over time.
- MLPs are subject to sector-specific risks, interest rate risks, and complex tax filing requirements.
- Investors must evaluate their access methods and consider potential tax implications, especially for IRAs.
Conclusion: Investing in Master Limited Partnerships (MLPs) can be a lucrative strategy due to their tax advantages and high-income potential. However, investors must be aware of the associated risks and the complexities of tax filings. Proper evaluation and understanding of MLP structures can help investors make informed decisions.
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Notes:
- Frequent readers will note that this is not unlike REITs, which are described in detail here: http://www.empirical.net/real-estate-investment-trusts/
- See our post on private equity for more details: http://www.empirical.net/introduction-private-equity/
- This is an important consideration, as Form K-1 can be significantly more difficult and time-consuming to complete.
