Master Limited Partnerships (MLPs)
Some investors may have fears toward partnerships in general; it is important to know MLPs are regulated by the Securities and Exchange Commission (SEC) and must comply with Sarbanes-Oxley, just like other publicly traded companies. These conditions are attractive to investors as they mean MLPs file annual and quarterly statements, notify investors of any material changes that affect the business, and are mandated to utilize enhanced accounting rules as enacted by Congress.
According to the National Association of Publicly Traded Partnerships, the MLP structure is limited to companies that receive 90 percent or more of their income from interest, dividends, real estate rents, gain from the sale or disposition of real property, income and gain from commodities or commodity futures, and income and gain from mineral or natural resources activities. While there are a few exceptions, the vast majority of Master Limited Partnerships (MLPs) operate in the energy industry.
The focus on the energy industry stems from a section of the U.S. tax code that indicates MLPs must operate in certain industries, which mostly pertain to the use of natural resources (read: petroleum, natural gas extraction and transportation).
Tax benefits of Master Limited Partnerships (MLPs) and considerations
While Master Limited Partnerships (MLPs) trade on stock exchanges such as the NYSE, American and NASDAQ just as companies such as General Electric and Microsoft do, the big difference is that because MLPs are not corporations, they do not pay a corporate tax. This "tax quirk" is in sharp contrast to the experience of shareholders in a corporation (most corporations) that face double taxation—paying taxes first at the corporate level and then at the personal level when those earnings are received as dividends—owners of a partnership are taxed only once, at the individual level.
Because Master Limited Partnerships (MLPs) do not pay corporate taxes, all tax items pass through to the partners, which in theory leave more of the MLP's earnings available to distribute to the unit holder (you). Moreover, for the majority of the time you hold your MLP position (units) you may not have to pay tax on the distributions the way you do on corporate dividends. Specifically, distributions are considered a tax-deferred return of capital, which is to say, a distribution that reflects a return of your initial investment. As you receive return of capital distributions, it reduces the tax basis of your partnership units. And these disbursements are not taxed as current income.
Additionally, the unit holder (investor) may also recognize a pro-rated share of the MLP's depreciation on their tax form which serves to reduce the unit holder's tax liability.
Although the tax advantages of Master Limited Partnerships are very attractive, there are some potential drawbacks. One such drawback of Master Limited Partnerships (MLPs) is that you are responsible for paying tax on your share of the partnership's taxable income. Dividends paid to shareholders by corporations are considered to be "qualified" and therefore, taxed at a lower, 15 percent tax rate. This is not the case with cash distributions paid by Master Limited Partnerships (MLPs). However, cash distributions usually exceed the partnership's taxable income which may negate the "net" impact of the taxable income.
Another consideration when owning Master Limited Partnership is that your personal "tax complexity" usually increases. Specifically, tax reporting can be more complex than investing in common stocks because you will receive Schedule K-1 from the partnership as opposed to a 1099. The K-1 will reflect your share of income and losses of the MLP and must be reflected on your tax return. And for unit holders with significant positions, there is the potential of reaching state thresholds (your tax adviser can help you identify the thresholds) that would require you to file tax returns in the various states in which the partnership operates.
Finally, Master Limited Partnerships may not be attractive in tax-deferred IRAs because the partnership may generate taxable income in any given year. Tax considerations for institutional investors limit their participation and mutual funds have been slow to invest in Master Limited Partnerships (MLPs). Consequently, the pool of potential investors is limited and may reduce liquidity for unit holders. At the time of sale, units may be worth more or less than their original cost.
Please recognize that the aforementioned "tax considerations" are by no means exhaustive and are for informational purposes only. Therefore, you should carefully consider the pros and cons of investing in MLPs and consult your tax adviser to fully determine the tax implications of any investment.
In conclusion, Master Limited Partnerships may be a solid choice for income-oriented investors as most offer very attractive yields that generally fall into the five to seven percent range. Further, said yields often receive favorable tax treatment. As with most tax-favorable investments, there is some "tax grief" associated with MLPs; however, for some the advantages far exceed the disadvantages. Overall, while Master Limited Partnerships (MLPs) are not well understood, they may be one of the most tax efficient vehicles available to the investing public. And while there are a few exceptions, the vast majority of Master Limited Partnerships operate in the energy industry.
Because MLPs tend to be involved in the energy field, when one considers becoming a unit holder, it begs the question of where do you think energy prices are going over the next 10 years? The next 20 years? Higher or lower? Good luck!