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Master Limited Partnerships (MLPs) Explained
A Master Limited Partnership is a publicly traded limited partnership. This sounds like a circular reference, but it isn’t. Limited partnerships are used often for non-public companies whereby several limited partners pool together their money and resources and start a venture that is run by a person or entity called the General Partner. These ventures are often used in private real estate transactions, where, for example, the limited partnership might purchase an office building and select one member of the group to run the building, thus acting as the general partner. The vast majority of the profits flows through the limited partnership to the partners for tax purposes, while the partners enjoy the protection of a corporate structure—thus “limiting” their liability to their capital investment.
This is exactly what happens with a Master Limited Partnership, except that the funds are raised via an offering of units to the public. In this way, MLPs are similar to a publicly traded corporation. In many other ways, however, there are distinct differences, which may make them an attractive addition to your portfolio or, possibly, something to avoid.
To dig a bit deeper, as noted above, MLPs have two separate partners, a General Partner and a Limited Partner. The General Partner runs the company’s operations and holds all the voting power and the Limited partner provides the capital and reaps the benefits of the distribution payments. The entity is geared toward the distribution of profits and, legally, must pass along the vast majority of its earnings to the partners. The General Partner is paid for its efforts via a management fee; however, it is normally paid an additional incentive fee for increasing the distribution to the Limited Partners. The MLPs “shares”, which are called units, are publicly traded and make up the vast majority of the partnership. These units comprise the limited partners’ stake in the entity.
The Limited Partnership business structure helps MLPs avoid direct federal and state corporate income taxes, allowing these companies to pass larger distributions to their “partners” (i.e. unit holders). Indeed, MLPs avoid the double-taxation problem that corporations face when paying dividends because the tax burden falls on the partners, who are responsible for paying the tax on their portion of the MLP's income. Note, however, that due to the nature of the businesses that typically falls under the Limited Partnership model, a significant portion of the distribution can wind up being considered a non-taxable return of capital (which lowers the cost basis of the original share purchase).
The flow-through nature of these entities is very different from normal corporations that trade on exchanges and, thus, the tax issues surrounding them can become complex. Details on the specific tax burden an investor faces is available through the K-1 (similar to a 1099-Div form) that every partnership distributes yearly. To highlight how complex the tax issues can get, consider that since the earnings of an MLP flow through to the unit holder, the holders actually earns income in the states in which the income was generated. Thus, investors that hold large positions in an MLP may have to file taxes in multiple states where they “earned” income based on their ownership stake in the MLP. Suffice it to say, the tax issues surrounding MLPs may require the help of a tax professional to sort out. Furthermore, there are limits on the amount of LP income that can be earned in a tax-exempt account. As such, large positions in an IRA are not recommended.
In order to avoid exploitation of this favorable tax treatment, Congress has strengthened regulation on MLPs so that the source of revenues must be from a “qualified” source, which generally means the revenues have to be derived from the natural resource and/or energy infrastructure businesses—however this is not always the case, as there are MLPs that own cemeteries (StoneMor (STON)), amusement parks (Cedar Fair (FUN)), as well as financial entities (AllianceBernstein (AB)).
The general focus on distributions inherent in the MLP structure generally leads to a need for a steady cash flow stream. Therefore, many MLPs are involved in businesses that are less affected by the business cycle, such as the midstream (pipeline) businesses. Kinder Morgan (KMP), Magellan Midstream (MMP), and Alliance Resource (ARLP) are examples of Limited Partnerships in the energy infrastructure sector. These companies have a stable and predictable cash flow stream that is often derived from contracts based on capacity—not utilization. This is a very efficient structure for these companies and allows them to pass on higher distributions and tax savings to their unit holders.
While Midstream may be the most popular business model to be structured as an MLP, other sectors, as noted above, including Exploration and Production, Shipping, Real Estate, and other energy infrastructure businesses, are structured as MLPs. Generally, these other companies are structured in this way to take advantage of the tax and distribution advantages of the MLP structure. Although many of these industries are also less affected by the business cycle, providing stable cash flow distribution to their partners, some are more volatile. Exploration and Production entities such as Linn Energy (LINE), for example, will take the initial funds raised by their IPO and invest in already proven and, most of the time, already producing fields. These companies then focus on increasing efficiency in the field and lowering costs. This model provides partners with a safe and stable distribution, but commodity prices will still have an outsize impact on the ability to pay dividends. This is an efficient business model for E&P companies that are distribution oriented.
Regulatory risk is greatest for MLPs that aren’t involved in Real Estate or Natural Resources industries, such as the Financial Sector. This is particularly true for companies like AllianceBernstein and Blackstone Group (BX), which are under government scrutiny for using the MLP structure as a tax shield. Indeed, these non-traditional sectors are under pressure from regulators to disallow the favorable tax treatment that comes with the MLP structure. Investors should consider these risks before investing, as losing the favorable tax treatment would significantly affect these companies and the unit holders.
All of that said, investors that are interested in a high-yield investment may want to consider an MLP. However, investors need to be aware of the additional tax issues that fall on the investor. It’s also important to note that MLPs can sometimes exhibit low trade volumes, which may make it difficult to purchase or sell large positions quickly.