Master limited partnerships

What Is Master Limited Partnerships?

A Master Limited Partnership (MLP) is an investment vehicle structured as a limited partnership but whose ownership interests are publicly traded on a securities exchange. This unique structure combines the tax advantages of a private partnership with the liquidity of a publicly traded stock, making them a distinct entity within the broader category of tax-advantaged investments. As a pass-through entity, an MLP typically pays no corporate income tax; instead, profits and losses are passed directly to the unitholders, who are then responsible for their share of the tax liability. Master Limited Partnerships are primarily found in sectors with stable, predictable cash flows, such as the energy sector and infrastructure.

History and Origin

Master Limited Partnerships emerged in the early 1980s, primarily within the oil and gas industry. The first MLP, Apache Petroleum Company (APC), was formed by Apache Corporation in 1981, aiming to provide investors with exposure to oil and gas assets while maintaining a tax-efficient structure. Their success led to rapid adoption across various industries, including real estate and even sports teams. However, this broad application prompted legislative action. Congress passed the Revenue Act of 1987, which significantly limited the types of businesses that could qualify for MLP status. Under Section 7704 of the Internal Revenue Code, an MLP must derive at least 90% of its gross income from "qualifying sources," which are strictly defined to include activities related to the exploration, production, processing, storage, and transportation of natural resources, as well as certain real property rents¹⁴. This legislative change effectively focused the MLP structure almost exclusively on the energy and infrastructure sectors.

Key Takeaways

• Master Limited Partnerships (MLPs) are publicly traded entities taxed as partnerships, avoiding corporate income tax.
• MLPs must generate at least 90% of their income from "qualifying sources," primarily energy-related activities.
• Investors in MLPs are called unitholders (or limited partners) and receive periodic cash distributions.
• MLP investors receive a Schedule K-1 for tax reporting, which can be more complex than a typical 1099 form.
• The unique structure of MLPs combines the tax benefits of a partnership with the liquidity of exchange-traded securities.

Interpreting the Master Limited Partnerships

When evaluating Master Limited Partnerships, investors typically focus on their income-generating potential and the stability of their cash distributions. Unlike traditional corporations that pay dividends, MLPs distribute a significant portion of their available cash flow to unitholders. These distributions are often considered a "return of capital," which can offer tax deferral benefits by reducing the investor's cost basis in the units rather than being immediately taxed as ordinary income. The consistency and growth of these distributions are key indicators of an MLP's financial health and management's effectiveness. Investors also scrutinize the MLP's underlying assets, typically long-term contracts for pipelines or storage facilities, which often provide predictable, fee-based revenues largely insulated from commodity price volatility.

Hypothetical Example

Imagine Sarah invests $10,000 in an MLP that owns and operates natural gas pipelines. In the first year, the MLP generates significant cash flow, and Sarah receives $800 in cash distributions. For tax purposes, the MLP informs her that $700 of this distribution is considered a return of capital, while $100 is ordinary income.

Sarah's initial cost basis is $10,000. Because $700 of her distribution is a return of capital, her basis is reduced to $9,300 ($10,000 - $700). She would only owe taxes on the $100 of ordinary income in the current year. The tax on the $700 is deferred until she sells her units. If she later sells her units for $11,000, her capital gains would be calculated based on her adjusted cost basis of $9,300, rather than the original $10,000.

Practical Applications

Master Limited Partnerships are predominantly used in industries requiring substantial, long-term capital investment in assets that generate consistent cash flows. Their most common application is within the energy sector, specifically in what is known as "midstream" operations. This includes companies that own and operate pipelines, storage terminals, and processing facilities for oil, natural gas, and natural gas liquids¹³. These assets form the backbone of energy infrastructure, transporting resources from production sites to refineries and end-users. The fee-based nature of many midstream contracts means their revenues are often stable, regardless of fluctuations in commodity prices, making them attractive for investors seeking reliable income streams. Beyond energy, some MLPs can exist in other natural resources industries, such as timber or certain real estate activities, provided they meet the strict 90% qualifying income test.

Limitations and Criticisms

Despite their advantages, Master Limited Partnerships present several limitations and criticisms that investors should consider. One of the most frequently cited drawbacks is the complexity of their tax reporting. Rather than a simple 1099 form, MLP investors receive a Schedule K-1 from each MLP in which they hold units¹². These forms can be complex, often arriving later in the tax season, and may require investors to file state tax returns in multiple states where the MLP operates¹¹.

Another significant concern arises when MLPs are held in tax-advantaged accounts like Individual Retirement Accounts (IRAs). While MLPs are generally considered pass-through entities, they can generate Unrelated Business Taxable Income (UBTI)¹⁰. If the UBTI in a tax-advantaged account exceeds a certain threshold (currently $1,000), the investor's retirement account may be subject to taxes and additional filing requirements, negating some of the benefits of the tax-advantaged wrapper⁹. Furthermore, MLPs are subject to specific sector risks, as their fortunes are tied to the energy sector and natural resources industries. While midstream operations are often insulated from commodity price volatility, broader economic downturns or regulatory changes affecting energy consumption can impact their performance. Governance structures in MLPs can also differ from traditional corporations, with the general partner often having significant control and potentially less stringent fiduciary duties to limited partners⁸.

Master Limited Partnerships vs. Publicly Traded Partnership

The terms "Master Limited Partnership" (MLP) and "Publicly Traded Partnership" (PTP) are often used interchangeably, leading to some confusion, but they are not strictly identical. A Publicly Traded Partnership (PTP) is broadly defined by the Internal Revenue Code as any partnership whose interests are traded on an established securities market or are readily tradable on a secondary market⁷. A Master Limited Partnership (MLP) is a type of PTP that specifically meets the qualifying income test under Section 7704 of the IRS code, meaning at least 90% of its gross income must come from qualifying sources like natural resources or real estate activities⁶. While most PTPs are structured as MLPs due to the tax benefits, not all PTPs are MLPs. For instance, a PTP could theoretically be organized as a limited liability company that elects partnership taxation but does not meet the 90% qualifying income threshold for MLP status. Essentially, all MLPs are PTPs, but not all PTPs are MLPs. The key distinction lies in the type of income generated and the specific tax code requirements they meet.

FAQs

What is the primary advantage of investing in an MLP?

The primary advantage is their pass-through entity status, which means the MLP itself does not pay corporate income taxes. Instead, income and losses are passed directly to unitholders, avoiding the double taxation associated with corporate dividends⁵. Additionally, a significant portion of their cash distributions may be considered a return of capital, offering tax deferral benefits.

Are MLPs considered high-risk investments?

Like all investments, MLPs carry risks. While midstream MLPs, which constitute a large portion of the sector, often have stable, fee-based revenues, they are still subject to energy sector specific risks, interest rate risks, and the overall economic environment⁴. The complexity of their Schedule K-1 tax forms and the potential for Unrelated Business Taxable Income (UBTI) in tax-advantaged accounts also add to their unique risk profile.

How do I receive income from an MLP?

MLPs typically pay regular cash distributions to their unitholders, usually on a quarterly basis. These distributions are similar to dividends from stocks, but they are often treated differently for tax purposes, with a portion commonly classified as a return of capital², ³.

Can I hold MLPs in my IRA?

While it is possible to hold MLPs in an IRA, it may not always be advantageous due to the potential for Unrelated Business Taxable Income (UBTI)¹. If the UBTI generated by the MLP in your IRA exceeds $1,000, your IRA could be subject to taxes and additional tax filing requirements (IRS Form 990-T), potentially undermining the tax-deferred benefits of the retirement account. It's often recommended to consult a tax advisor before investing in MLPs within an IRA.