Master limited partnership

What Is Master Limited Partnership?

A master limited partnership (MLP) is a unique business structure that combines the tax advantages of a private limited partnership with the liquidity of a publicly traded company. As an investment vehicle, MLPs trade on public exchanges, allowing investors to buy and sell "units" similar to how shares of stock are traded. MLPs are commonly found in capital-intensive industries such as energy, including the transportation, processing, and storage of oil, natural gas, and other natural resources. They are considered pass-through entities for tax purposes, meaning the partnership itself does not pay federal income tax. Instead, profits and losses are passed directly to the investors, known as limited partners, who then report their share on their individual tax returns.²¹

History and Origin

The concept of the master limited partnership originated in 1981 with Apache Corporation's formation of Apache Petroleum Company. Initially, MLPs were adopted across a variety of industries, including real estate, hotels, and even sports teams like the Boston Celtics.²⁰ However, this widespread adoption raised concerns in Congress about potential losses in corporate taxation revenue due to MLPs avoiding double taxation.¹⁹

In response, the U.S. Congress passed the Revenue Act of 1987. This legislation significantly restricted the types of businesses that could qualify as MLPs. Specifically, it mandated that at least 90% of an MLP's gross income must come from "qualifying sources," which were strictly defined to include activities related to the exploration, production, processing, storage, and transportation of natural resources and minerals, as well as real property rents.¹⁷, ¹⁸ This act effectively limited the MLP structure primarily to the energy and real estate sectors, shaping the landscape of MLPs seen today.

Key Takeaways

• A master limited partnership (MLP) combines the tax benefits of a private partnership with the trading liquidity of a public company.
• MLPs are primarily found in the energy sector, due to legal requirements that 90% of their income must be from qualifying sources related to natural resources or real estate.
• They operate as pass-through entities, avoiding corporate income tax; income and losses are passed directly to unitholders.¹⁶
• Investors in MLPs receive regular cash distributions, which are generally not taxed at the entity level but can reduce the investor's cost basis in their units.¹⁵

Interpreting the Master Limited Partnership

Interpreting a master limited partnership (MLP) involves understanding its unique operational and tax structure. Unlike a traditional corporation, an MLP's financial performance is often evaluated based on its cash flow rather than net income. This is because MLPs are incentivized to distribute available cash to their unitholders.¹⁴ These cash distributions, often made quarterly, are a primary draw for investors seeking a steady stream of income. The value of an MLP unit is often tied to its distribution yield and the stability and predictability of its underlying cash flows.¹³

Moreover, understanding the two classes of partners—general partners and limited partners—is crucial. General partners manage the MLP's day-to-day operations and typically hold a smaller ownership stake, often around 2%, but have incentive distribution rights that allow them to receive a larger share of cash flow as distributions grow. Limited partners are the investors who provide capital and receive the bulk of the distributions. The¹² specific terms governing these relationships are outlined in the partnership agreement.

Hypothetical Example

Consider "PipelineFlow MLP," a hypothetical master limited partnership involved in transporting natural gas. An investor, Alice, purchases 100 units of PipelineFlow MLP at $25 per unit. During the year, PipelineFlow MLP generates $100,000 in qualifying income from its pipeline operations and incurs $60,000 in expenses, including depreciation. The MLP decides to distribute all available cash, which amounts to $0.30 per unit per quarter.

Alice receives quarterly distributions of $30 ($0.30 per unit * 100 units). At the end of the year, she receives a total of $120 in distributions. Because PipelineFlow MLP is a pass-through entity, it sends Alice a Schedule K-1 tax form, reporting her share of the MLP's taxable income, deductions, and credits. This means that while Alice received cash, a portion of her distribution may be considered a return of capital due to depreciation, which reduces her cost basis in the units rather than being immediately taxable as ordinary income. She reports this information on her individual income tax return.

Practical Applications

Master limited partnerships are predominantly found within the energy infrastructure sector, including companies involved in pipelines, storage facilities, and processing plants for oil, natural gas, and refined products. The¹⁰, ¹¹ir structure allows for the financing of large, capital-intensive projects while offering investors attractive cash flows and certain tax benefits. For example, Energy Transfer LP, a major MLP, acquired Crestwood Equity Partners LP in an all-equity transaction valued at approximately $7.1 billion, including assumed debt, expanding its footprint in key production basins. This type of transaction highlights how MLPs are used to consolidate assets and achieve economies of scale within the energy industry. MLPs' income stream and growth prospects are closely tied to the demand for energy and the infrastructure required to deliver it.

##⁹ Limitations and Criticisms

Despite their advantages, master limited partnerships come with specific limitations and criticisms. A primary concern for investors relates to tax complexity. Instead of a standard Form 1099, MLP investors receive a Schedule K-1 (Form 1065) from the partnership, which details their share of the MLP's income, deductions, and credits. Thi⁸s form can be more complex to interpret and report on an individual income tax return, particularly for those unfamiliar with partnership taxation.

Fu⁵, ⁶, ⁷rthermore, MLPs can generate Unrelated Business Taxable Income (UBTI), which can be taxable even within a tax-advantaged account like an individual retirement account (IRA) if the amount exceeds a certain threshold. This can negate some of the tax benefits typically associated with IRAs and necessitates careful consideration or consultation with a tax professional. The⁴ performance of MLPs can also be sensitive to changes in interest rates and legislative shifts that could impact their pass-through tax structure. For³ investors seeking MLP exposure without these complexities, an exchange-traded fund (ETF) that invests in MLPs may offer a simpler alternative. The U.S. Securities and Exchange Commission (SEC) provides investor bulletins highlighting the unique aspects and potential risks associated with MLPs.

Master Limited Partnership vs. Limited Partnership

The distinction between a master limited partnership (MLP) and a general limited partnership (LP) primarily lies in their tradability and scale. Both structures feature a general partner who manages the business and has unlimited liability, and limited partners whose liability is limited to their investment. However, a traditional limited partnership is typically a private arrangement, with ownership interests not publicly traded. Investors in an LP directly participate in the partnership's operations to a limited extent and exit strategies often involve a private placement or negotiation with other partners.

In contrast, a master limited partnership is a publicly traded entity. Its units are listed and exchanged on national securities exchanges, providing investors with the ability to buy and sell their interests with relative ease, similar to corporate stock. This public tradability offers a level of liquidity that is absent in private limited partnerships. Additionally, MLPs are subject to specific IRS regulations regarding their income sources to maintain their pass-through tax status, a requirement not imposed on private LPs. This distinction makes MLPs a hybrid structure, blending aspects of both partnerships and corporations.

FAQs

What is the primary advantage of investing in an MLP?

The primary advantage of investing in a master limited partnership (MLP) is that it combines the tax benefits of a partnership (avoiding corporate-level taxation) with the liquidity of a publicly traded security. This often allows MLPs to offer higher cash distributions to investors.

##²# How are MLP distributions taxed?
MLP distributions are generally treated as a return of capital, which means they are not immediately taxed as income tax. Instead, they reduce the investor's cost basis in the MLP units. Taxes are typically due when the units are sold, or if the distributions exceed the investor's cost basis. Investors receive a Schedule K-1 tax form detailing their share of the MLP's income, deductions, and credits.

Can I hold MLPs in my retirement account?

Yes, you can hold master limited partnerships (MLPs) in a retirement account like an individual retirement account (IRA). However, if the MLP generates over $1,000 in Unrelated Business Taxable Income (UBTI) within the IRA during a year, that income may be subject to immediate taxation, which can complicate the tax treatment of your retirement account.

What kind of companies typically form MLPs?

Due to U.S. tax regulations, companies that form master limited partnerships (MLPs) typically derive at least 90% of their income from "qualifying sources." This primarily includes businesses involved in the transportation, processing, storage, and production of natural resources, such as oil, natural gas, and other minerals, as well as real estate.

Are MLPs considered high-risk investments?

MLPs are generally considered to offer a stable income stream, particularly those in the energy midstream sector with fee-based contracts. However, like all investments, they carry risks, including sensitivity to interest rate changes, commodity price fluctuations (depending on the MLP's specific operations), and legislative changes to tax laws. Their tax complexity can also be a consideration for some investors.¹