The Master Limited Partnership (MLP) is a special type of limited partnership that is traded on a securities exchange like shares of any ordinary corporation. MLPs combine investment, tax, and risk features that offer many advantages and make them attractive to own. An MLP is a publicly traded partnership that the IRS treats as a corporation. It has many of the tax advantages of a limited partnership along with the liquidity offered by a publicly traded security. MLPs allow investors to invest in the transport and processing of energy products such as natural gas, coal, and oil. As investments, these industries appear to have a logical place in your portfolio.
Most MLPs are involved with the energy industry. They are involved in the processing, storing and transporting of energy resources, including pipelines, terminals, and storage facilities. They are not typically involved in energy resource exploration or extraction. Their role is in the delivery of intermediate or final energy products to processors or to the end user. This role limits many of the risks associated with potentially volatile pricing of energy products.
MLPs are mandated to distribute nearly all of the cash flow generated from business activities to investors on a quarterly basis. MLPs are structured so that management is incentivized to boost the quarterly distributions to their investors who are termed unitholders. This distribution is analogous to dividends and has been averaging 6% or more. The overall return of an MLP investment includes the dividend plus appreciation of the price of the MLP. Appreciation has been averaging 4-8% resulting in total returns in the 10-14% range.
Advantages of MLPs
There are several advantages to MLPs. The quarterly distributions provide regular income. Tax advantages inherent in MLP investments is centered on the passthrough of income to the individual and avoidance of corporate income taxes. For the first five years following the investment, approximately 80% of cash payouts are not taxable. Capital gain taxes enter into consideration only when the security it is sold. Some of the expenses attributed to depreciation may also be passed through to the investor adding to tax benefits. These make MLP investments particularly attractive to investors who are harvesting tax-advantaged income.
MLPs are also valuable because there is little correlation between MLP and equity investments. Since MLP business activities involve providing energy, the demand for it is relatively stable except possibly in a severe economic downturn.
The major risk of an MLP investment is usually related to its management. The success of the firm is heavily influenced by its management. Political risk, particularly related to regulatory agencies and the IRS, interest rate risk and routine business risks affecting many different types of businesses are of course present.
The disadvantages of MLPs include their not being optimal for some tax-deferred accounts. In addition, tax reporting may be cumbersome. For example, pipeline MLPs may require filing of personal tax returns in every state the pipeline traverses. The familiar 1099 tax forms are replaced by K-1 (partnership) forms. In mid‑2010 MLP ETFs and mutual funds appeared. These facilitated the investors’ purchases of MLPs, but could require expertise in order to maintain the MLP tax efficiency. Personal tax implications may require consultation with your financial advisor. In summary, MLPs can be a valuable addition to one’s portfolio.