Master limited partnerships mlps

What Are Master Limited Partnerships (MLPs)?

Master Limited Partnerships (MLPs) are a type of publicly traded investment vehicle that combines the tax advantages of a private partnership with the liquidity of publicly traded securities. MLPs belong to the broader financial category of alternative investments. Unlike corporations, which are subject to corporate income tax on their earnings before distributing dividends to shareholders, MLPs are structured as pass-through entities. This means the income, deductions, and credits generated by the MLP are passed directly to the investors, known as unitholders, who then report these items on their individual tax returns. MLPs typically issue "units" rather than shares.¹⁶

The unique structure of a Master Limited Partnership avoids the double taxation that applies to traditional corporations. To qualify for this favorable tax treatment, an MLP must derive at least 90% of its gross income from qualifying sources, primarily related to the production, processing, storage, and transportation of natural resources and minerals, such as oil, natural gas, and refined petroleum products.

History and Origin

The concept of Master Limited Partnerships emerged in the United States in the early 1980s. The first MLP, Apache Petroleum Company (APC), was formed by Apache Corporation in 1981, aiming to provide investors with a liquid way to invest in oil and gas assets while retaining the tax benefits of a partnership. The success of this model quickly led to its adoption by other energy companies, and soon, MLPs expanded into other sectors like real estate, hotels, and even sports teams.

However, the rapid proliferation of MLPs beyond their initial intent prompted a response from Congress. To curb the use of the MLP structure for businesses not engaged in traditional natural resource activities, the U.S. government enacted Section 7704 of the Revenue Act of 1987. This legislation significantly restricted the types of businesses that could qualify as MLPs, mandating that at least 90% of an MLP's income must come from "qualifying sources," primarily defined as activities related to natural resources and real property rents. This legislative action solidified the MLP's role as a specialized investment vehicle predominantly focused on the energy and infrastructure sectors.

Key Takeaways

• Master Limited Partnerships (MLPs) are publicly traded partnerships that combine the tax benefits of a partnership with the liquidity of publicly traded securities.
• MLPs are pass-through entities, meaning their income, deductions, and credits flow directly to investors (unitholders) who report them on their individual tax returns, avoiding corporate-level taxation.
• To qualify as an MLP, at least 90% of the entity's gross income must come from qualifying sources, predominantly related to natural resources.¹⁵
• Investors in MLPs receive quarterly distributions, which are generally considered a return of capital and are largely tax-deferred until the units are sold.¹⁴
• MLP investors receive a Schedule K-1 for tax reporting, which can be more complex than a standard Form 1099.

Formula and Calculation

While there isn't a single "formula" for a Master Limited Partnership itself, understanding the tax implications for unitholders involves calculating the adjusted cost basis of their units. Distributions from an MLP are typically treated as a return of capital, which reduces the unitholder's cost basis. This deferral of taxes on distributions is a key benefit.

The general principle for basis adjustment is:

[ \text{Ending Basis} = \text{Beginning Basis} + \text{Share of Income} - \text{Distributions} ]

Where:

• (\text{Ending Basis}) represents the unitholder's capital account at the end of the tax year.
• (\text{Beginning Basis}) represents the unitholder's capital account at the start of the tax year.
• (\text{Share of Income}) includes the unitholder's proportionate share of the MLP's taxable income, as reported on Schedule K-1.
• (\text{Distributions}) are the cash payments received by the unitholder from the MLP.

This calculation is critical for determining the capital gains or losses when the MLP units are eventually sold.

Interpreting the MLP

Master Limited Partnerships are primarily interpreted as income-generating investments, often favored for their relatively high distributions and tax-advantaged structure. Investors evaluate MLPs based on factors such as their distribution yield, the stability and growth prospects of their underlying assets (e.g., pipelines), and the quality of the general partner. The consistent cash flow generated by many MLPs, particularly those in midstream energy infrastructure, is a significant draw for investors seeking steady income.

However, interpreting an MLP also requires careful consideration of its tax implications. Because MLPs are pass-through entities, investors receive a Schedule K-1 form for tax reporting, which details their share of the partnership's income, deductions, and credits. This document can be more complex than a standard Form 1099 received from corporate stock dividends, potentially requiring more effort for tax preparation. The distributions received are largely tax-deferred, reducing the investor's cost basis, which impacts the eventual gain or loss upon sale.¹³

Hypothetical Example

Imagine an investor, Sarah, purchases 1,000 units of "Pipeline Peak MLP" at an initial price of $25 per unit, for a total investment of $25,000. Pipeline Peak MLP primarily operates natural gas pipelines.

In the first year, Pipeline Peak MLP distributes $2 per unit to unitholders. Sarah receives $2,000 in distributions. On her annual Schedule K-1 from the MLP, her share of the partnership's taxable income is reported as $0.50 per unit, or $500 total.

Sarah's initial cost basis is $25,000. The $2,000 in distributions she received is treated as a return of capital. Her adjusted cost basis is calculated as:

Initial Cost Basis - Distributions (return of capital portion) = Adjusted Cost Basis
$25,000 - $2,000 = $23,000

The $500 of taxable income flows through to her personal tax return. This effectively means that while she received $2,000 in cash, only $500 is immediately taxable. The remaining $1,500 reduces her cost basis. This deferral of taxes on a portion of the distribution is a key characteristic of MLPs. Should Sarah sell her units later, the lower adjusted cost basis would result in a higher taxable gain or lower deductible loss. Understanding the tax implications of such adjustments is crucial for investors.

Practical Applications

Master Limited Partnerships are predominantly found in the energy sector, particularly within midstream operations. These include companies involved in the transportation, storage, and processing of oil, natural gas, and other refined products.¹² Their structure is particularly well-suited for capital-intensive industries that generate consistent cash flows, as the pass-through taxation allows for a higher distribution of income to investors without the burden of corporate taxes.

For investors, MLPs can serve as an income-generating component within a diversified investment portfolio. They often offer higher yields compared to traditional stocks and bonds, due in part to their favorable tax structure.¹¹ Beyond the energy sector, some MLPs may also exist in real estate or other qualifying infrastructure projects, though the energy focus remains dominant. Investors receive a Schedule K-1, a tax document that outlines their share of the MLP's income, deductions, and credits.⁸, ⁹, ¹⁰ This form is necessary for filing individual tax returns and understanding the full financial picture of the investment.⁷

Limitations and Criticisms

Despite their advantages, Master Limited Partnerships come with specific limitations and criticisms. One of the most significant drawbacks is the complexity of their tax reporting. Investors in MLPs receive a Schedule K-1, which can be more intricate than the typical Form 1099 issued for stock dividends. This complexity often necessitates professional tax assistance, adding to the investment costs. Furthermore, unitholders may be subject to state income taxes in every state where the MLP operates, potentially increasing their tax burden and administrative complexity.

Another criticism revolves around the limited appreciation potential of MLPs. While they are known for their income distributions, the growth in unit price may be less significant compared to growth stocks. Additionally, MLPs are sensitive to changes in interest rates and legislative changes to tax codes, which could impact their pass-through tax structure.⁶ An important consideration for investors holding MLPs in tax-advantaged accounts, such as IRAs, is the potential for Unrelated Business Taxable Income (UBTI), which can be taxable even within these accounts if it exceeds certain thresholds.⁵

Master Limited Partnership (MLP) vs. Real Estate Investment Trust (REIT)

While both Master Limited Partnerships (MLPs) and Real Estate Investment Trusts (REITs) are investment vehicles known for their income-generating potential and pass-through tax structures, they differ significantly in their underlying assets and qualifying income sources.

The fundamental distinction lies in the nature of the assets they hold and the type of income they generate. MLPs are tied to natural resources and their infrastructure, while REITs are focused on real estate. This difference dictates their primary revenue streams and the specific tax regulations they must adhere to to maintain their pass-through status.

FAQs

How are MLP distributions taxed?

MLP distributions are generally considered a "return of capital," which means they typically reduce the investor's cost basis in the MLP units. Taxes are often deferred on a significant portion of these distributions until the units are sold. However, investors are still responsible for their share of the MLP's taxable income, deductions, and credits, which are reported on a Schedule K-1.⁴

Do MLPs issue a Form 1099 or a Schedule K-1?

Master Limited Partnerships issue a Schedule K-1 to their investors, not a Form 1099. The Schedule K-1 details the investor's share of the MLP's income, losses, deductions, and credits for the tax year.³

Are MLPs suitable for retirement accounts?

Investing in MLPs within retirement accounts like IRAs or 401(k)s can lead to Unrelated Business Taxable Income (UBTI). If the UBTI exceeds a certain threshold (currently $1,000 annually), it may be subject to taxation even within the tax-advantaged account. Investors should consult with a tax advisor to understand the potential implications of holding MLPs in such accounts.²

What are the main types of MLPs?

The majority of Master Limited Partnerships operate in the energy sector. They are commonly categorized into three types based on their activities within the energy value chain: upstream (exploration and production), midstream (transportation and storage via pipelines), and downstream (processing and refining). Midstream MLPs are the most prevalent due to their stable, fee-based cash flows.¹

What is a general partner in an MLP?

In an MLP, the general partner is responsible for the day-to-day management and operation of the partnership. The general partner typically holds a small ownership stake but often has significant control and may receive incentive distribution rights based on the MLP's payouts. Limited partners, or unitholders, are the investors who provide capital and have limited liability.