The Benefits of Master Limited Partnerships (MLPs)

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The Benefits of Master Limited Partnerships (MLPs)

A master limited partnership (MLP) is an unusual investment that combines the tax benefits of a limited partnership (LP) with the liquidity of a common stock. It is organized as a publicly traded partnership (PTP), a type of LP where the limited partners’ shares are freely traded on securities exchanges. Thus, while an MLP has a partnership structure, it issues shares that trade on an exchange like common stock.

Today’s MLPs are defined by the Tax Reform Act of 1986 and the Revenue Act of 1987, which outline how companies can structure their operations to realize certain tax benefits and define which companies are eligible. To qualify, a firm must earn 90% of its income through activities or interest and dividend payments relating to natural resources, energy, commodities, or real estate. If a company does qualify, an MLP can provide it with a variety of benefits.

Key Takeaways

  • A master limited partnership (MLP) is a company organized as a publicly traded partnership (PTP).
  • MLPs combine a private partnership’s tax advantages with a stock’s liquidity.
  • MLPs have two types of partners; a general partner, who manages the MLP and oversees its operations, and limited partners, who are investors in the MLP.
  • Investors receive tax-sheltered distributions from the MLP.
  • MLPs are considered relatively low-risk, long-term investments, providing a slow but steady income stream.
  • MLPs are usually found in the natural resources, energy, and real estate sectors.

Tax Benefits

Tax implications for MLPs differ significantly from those for corporations for both the company and its investors. Like other LPs, there is no tax at the company level. This essentially lowers an MLP’s cost of capital, as it does not suffer the problem of double taxation on dividends. Companies that are eligible to become MLPs have a strong incentive to do so because it provides a cost advantage over their incorporated peers.

In an MLP, instead of paying a corporate income tax, the tax liability of the entity is passed on to its unitholders. Once a year each investor receives a K-1 statement (similar to a 1099-DIV form) detailing their share of the partnership’s net income, which is then taxed at the investor’s individual tax rate.

One important distinction must be made here: While the MLP’s income is passed through to its investors for tax purposes, the actual cash distributions made to unitholders have little to do with the firm’s income. Instead, cash distributions are based on the MLP’s distributable cash flow (DCF), which is similar to free cash flow (FCF). Unlike dividends, these distributions are not taxed when they are received. Instead, they are considered reductions in the investment’s cost basis and create a tax liability that is deferred until the MLP is sold.

Fortunately for investors, MLPs generally have much higher distributable cash flow than they have taxable income. This is a result of significant depreciation and other tax deductions and is especially true of natural gas and oil pipeline and storage companies, which are the most common businesses to choose an MLP structure.

Investors then receive higher cash payments than the amount upon which they are taxed, creating an efficient means of tax deferral. The taxable income passed on to investors often is only 10% to 20% of the cash distribution, while the other 80% to 90% is deemed a return of capital and subtracted from the original cost basis of the initial investment.

The first MLP was organized in 1981. However, by 1987 Congress effectively limited the use of them to the real estate and natural resources sectors. These limitations were put into place out of a concern over too much lost corporate tax revenue; MLPs do not pay federal income taxes.

MLP Cash Flows and Taxes

Let’s look at an example of the mechanics of cash flows and taxes that occur when holding and selling MLPs. Assume that an MLP is purchased for $25 per share, held for three years, makes cash distributions of $1.50 per unit per year, and passes through $0.30 of taxable income to each unit per year.

First, calculate the change in cost basis caused by the net return of capital—cash distributions minus allocation of taxable income—over the life of the investment. For simplicity, assume taxable income and cash distribution remain constant through the life of the investment, although in reality these probably would fluctuate each year.

Year 1 Year 2 Year 3
Cost Basis at Beginning of Year $25.00 $23.80 $22.60
Allocation of Taxable Income $0.30 $0.30 $0.30
Cash Distributions $1.50 $1.50 $1.50
Net Reduction of Cost Basis $1.20 $1.20 $1.20
Adjust Cost Basis at End of Year $23.80 $22.60 $21.40

If the MLP is sold at the end of the third year for $26 per unit, the investor would show a gain of $4.60. One dollar of this would be a normal capital gain—having bought at $25 and sold at $26—and would be taxed at the long-term capital gains tax rate. The remaining $3.60 gain results from the $1.20 return of capital each year, and this amount would be taxed at the investor’s personal income tax rate. The table below shows cash flows, including those related to taxes, during the life of the investment. We assume a 35% income tax rate and a 15% capital gains rate.

Cash Flows Year 1 Year 2 Year 3
Purchase of Security -25.00 $23.80 $22.60
Income Tax From Allocation of MLP Income ($0.30 x 35%) -$0.11 -$0.11 -$0.11
Cash Distributions $1.50 $1.50 $1.50
Sale of Security $26.00
Capital Gains Tax on Difference Between Purchase Prices and Sale Price -$0.15
Income Tax on Difference Between Purchase Price and Adjusted Cost Basis at End of Year Three ($3.60 x 35%) -$1.26
Total: -23.61 $1.39 $25.98

An important side note on the concept of reducing cost basis: If and when the investment’s cost basis falls to zero, any cash distribution becomes immediately taxable, rather than being deferred until the sale of the security. This is because the investment cannot fall into a negative cost basis. This can occur if an MLP is held for many years.

MLPs can be used to gain current income while deferring taxes, as seen in the above example. This can be taken one step further when an MLP investment is used as a vehicle for estate planning. When an MLP unitholder dies and the investment is transferred to an heir, the cost basis is reset to the market price on the transfer date, eliminating any accrued tax liability caused by a return of capital.

Diversification Benefits

Investors can benefit by investing in MLPs, as they are not highly correlated with other asset classes, including stocks, bonds, and commodities. Additionally, they have a correlation coefficient of less than 0.5 to both real estate investment trusts (REITs) and the S&P 500. This makes them good diversifiers.

Diversification is a widely used investment strategy to smooth out unsystematic risk events in a portfolio without sacrificing expected returns. It is intended to allow the positive performance of some investments to neutralize the negative performance of others. Diversification is only successful if the securities in the portfolio are not perfectly correlated. That is, they respond differently, often in opposing ways, to market influences.

Moreover, an investor interested in buying MLPs could consider investing in a portfolio of MLPs that is itself diversified across sectors in order to further reduce risk. For example, one could look to MLPs in the real estate, infrastructure, and renewable energy sectors.

Higher Yields

MLPs are known for offering relatively slow investment returns that stem from the fact that they are often established in capital-intensive and slow-growing industries, such as pipeline construction. This slow but steady growth means MLPs generate a stable income based on long-term service contracts and consistent cash distributions to investors.

The cash distributions of MLPs usually grow slightly faster than inflation. For limited partners, 80% to 90% of the distributions are often tax deferred. Overall, this lets MLPs offer attractive income yields that are often substantially higher than the average dividend yield of equities. Also, with the flow-through entity status (and avoiding double taxation), more capital is available for future projects. The availability of capital keeps the MLP firm competitive in its industry. 

29.2%

The level of potential yields from MLPs.

MLP Partnership Structure

MLPs contain two business entities: the limited partners and the general partner. The former invest capital into the venture and obtain periodic cash distributions, while the latter oversees the MLP’s operations and receives incentive distributions rights (IDRs). IDRs are structured when the partnership is formed and provide the general partner with performance-based pay for successfully managing the MLP, as measured by cash distributions to the limited partners.

The general partner usually receives a minimum of 2% of the LP distribution. However, as payment to LP unitholders increases, so does the percentage take of the general partner through IDRs, often to a maximum of 50%. The table below shows a hypothetical IDR structure outlining the payment split between limited partners and the general partner at different distribution levels.

LP Distribution per Unit Limited Partner General Partner
Tier 1 Below $1.00 98% 2%
Tier 2 Between $1.00 and $2.00 80% 20%
Tier 3 Between $2.00 and $3.00 65% 35%
Tier 4 Above $3.00 50% 50%

For each incremental dollar distributed to limited partners, the general partner realizes higher marginal IDR payments. For example, assuming 1,000 LP units outstanding, if $1,000 is distributed to limited partners ($1.00 per unit), then the general partner will receive $20 (2% of $1,000). However, if $5,000 is distributed to limited partners ($5.00 per unit), then the general partner will receive $2,810, as outlined below.

LP Distribution per Unit General Partner IDR Level General Partner Payment per LP Unit
Tier 1 $1.00 2% $0.02
Tier 2 $1.00 20% $0.25
Tier 3 $1.00 35% $0.54
Tier 4 $2.00 50% $2.00
Total $5.00 $2.81

The calculation for the general partner’s payment for each tier is not a straight multiplication of the general partner’s IDR by the LP’s distribution. The calculation is as follows: (LP distribution ÷ limited partner’s IDR) x general partner’s IDR. Thus, at the third tier, the general partner’s payment would be ($1 ÷ 0.65) x 0.35 = 0.538 (rounded to $0.54).

Here we see that the general partner has a significant financial incentive to increase cash distributions to limited partner unitholders; while distribution to limited partners increases 500%, from $1,000 to $5,000, distribution to the general partner increases by more than 14,000%, rising from $20 to $2,820. Note in the calculations in the above table that the IDR payment is not a percentage of the incremental limited partners distribution amount, but rather a percentage of the total amount distributed at the marginal level. For example, in the third tier, $1.54 is distributed per LP unit; $1.00 (65%) of that amount is paid to limited partners and $0.54 (35%) is paid to the general partner.

The corporate structure of MLPs can be more complex than a simple split between the limited and general partnership interests. In some cases the general partner may own LP shares. In other cases the general partnership of an MLP may be publicly traded, and have its own limited partner/general partner split. Or the MLP may have other relationships with additional entities due to financing arrangements. However, the most important relationship for the MLP investor to keep in mind is the cash distribution split between limited partners and the general partner and how this will change over time as distributions fluctuate.

Should You Own MLPs?

MLPs have remained relatively unknown in part because of their low level of institutional ownership and a consequent lack of sell-side attention. Mutual funds were largely restricted from owning MLPs until 2004, but even now MLPs present a cumbersome investment. This is because funds must send out 1099 forms to their investors detailing income and capital gains in November but may not receive K-1 statements from MLPs until February. This leads to the potential for costly mistakes in estimation.

Tax-exempt institutional investment funds, such as pensions, endowments, and 401(k) plans, are restricted from owning MLPs, because the cash distributions received are considered unrelated business taxable income (UBTI)—income that is unrelated to the activity that gives the fund tax-exempt status. This could create a tax liability on any distribution of more than $1,000. This is also true for individuals when holding MLPs in an individual retirement account (IRA); therefore, the best way to hold them is in a regular brokerage account.

Individual investors are the principal owners of MLPs. Because few individuals know much about their structure and complex tax implications, they are often purchased for individuals by private-client wealth managers, although this need not be the case. As long as the individual or their accountant understands how to manage the K-1 statement and cash distributions, this investment can be perfect for an investor seeking current income and tax deferral.

What Is the Difference Between a Limited Partnership (LP) and a Master Limited Partnership (MLP)?

A publicly traded partnership (PTP) is a type of limited partnership (LP) that is similar to a master limited partnership (MLP), and many MLPs are structured as PTPs. However, there can be some minor differences. PTPs, mostly in energy-related businesses, can offer investors quarterly income that receives more-favorable tax treatment. Additionally, not all MLPs are PTPs, because some are not publicly traded (although most are). And not all PTPs are MLPs; some could be publicly traded limited liability companies (LLC) that have decided to be taxed as a partnership.

What Happens When You Sell a Master Limited Partnership?

Just as with ordinary shares, when investors sell shares in MLPs for a profit they will face capital gains taxes. Holding periods of less than one year are treated as short-term capital gains, which are taxed as ordinary income. Holding periods of more than one year are taxed at the long-term capital gains rate, which is more favorable. Those sold for a loss will be treated similarly and can be used to offset capital gains elsewhere.

Are REITS Tax Exempt?

By law, REITs are required to pay out at least 90% of their taxable profits to shareholders as dividends. In return, REIT companies are exempt from most corporate income tax. Many REITs reinvest shareholder dividends, which offers deferred taxation and the compounding of gains.

The Bottom Line

Master limited partnerships (MLP) combine the tax benefits of a limited partnership with the liquidity of a common stock. To qualify to be an MLP, a firm has to earn 90% of its income through activities or interest and dividend payments related to natural resources, energy, commodities, or real estate.

Although these unusual investments are not well known, they can be attractive for individuals who are looking for current income and tax deferral.

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