Master Limited Partnership (MLP) Definition (2024)

What Is a Master Limited Partnership (MLP)?

A master limited partnership (MLP) is a business venture in the form of a publicly traded limited partnership. It combines the tax benefits of a private partnership with the liquidity of a publicly traded company.

A master limited partnership trades on an exchange. MLPs generally experience cash flow stability and are required by the partnership agreement to distribute a set amount of cash to their investors. Their structure can also help reduce the cost of capital in capital-intensive businesses such as the energy sector.

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

Understanding Master Limited Partnerships (MLPs)

The MLP is a hybrid legal entity that combines elements of two business structures—a partnership and a corporation. It is considered to be the aggregate of its partners rather than a separate legal entity (like a corporation).

An MLP technically has no employees. The general partners are responsible for providing all necessary operational services. General partners usually hold stakes of about 2% in the venture and have the option to increase their ownership.

An MLP issues units instead of shares. These units can be bought and sold on stock exchanges. As a result, they are a liquid security. Traditional partnerships cannot offer the same level of liquidity.

Since an MLP'spublicly traded unitsare not stock shares,those who invest in MLPs are commonly referred to as unitholders rather than shareholders.Those who buy into an MLP are called limited partners. These unitholders are allocated a share of the MLP's income, deductions, losses, and credits.

MLPs have two classes of partners:

• Limited partners are investors who purchase shares in the MLP and provide the capital for the entity's operations. They receive periodic distributions from the MLP, typically every quarter. Limited partners are also known as silent partners.
• General partners are the owners who are responsible for managing the day-to-day operations of the MLP. They receive compensation based on the partnership's business performance.

Tax Treatment of MLPs

Pass-Through Tax Consequences

An MLP is treated as a limited partnership for tax purposes, which is a significant tax advantage for investors.

A limited partnership has a pass-through, or flow-through, tax structure. This means that all profits and losses are passed through to the limited partners. The MLP itself pays no taxes on its revenues, unlike most incorporated businesses. Instead, the limited partners pay income taxes on their portions of the MLP's earnings.

Further, deductions, such as depreciation and depletion, also pass through to the limited partners. Limited partners can use these deductions to reduce their taxable income.

To maintain its pass-through status, at least 90% of the MLP's income must be qualifying income. Qualifying income includes income realized from the exploration, production, or transportation of natural resources or real estate.

In other words, to qualify as a master limited partnership, a company must generate all but 10% of its revenues from natural resources or real estate activities. This definition of qualifying income reduces the sectors in which MLPs can operate.

Deferred Taxes and the Capital Gains Tax Rate

Quarterly distributions from the MLP are not unlike quarterly stock dividends. However, a portion of a distribution is treated as a return of capital (ROC) rather than dividend income. So, the unitholder does not pay income tax on the distribution. Instead, the distribution reduces the cost basis of units.

The distributions remain tax-deferred until unitholders sell their interests in the MLP. Then, the difference between the cost basis and sale price is taxed at a combination of the ordinary income tax rate (on the return of capital distribution) and the capital gains tax rate (on the appreciation of the units since purchase). This is a significant, additional tax benefit.

Advantages and Disadvantages of MLPs

Like any investment, MLPs have their pros and cons.

Advantages

1. MLPsare known foroffering slow yet steady investment returns. The slow returns stem from the fact that MLPs are often in slow-growing industries like pipeline construction. This slow but steady growth means MLPs are low risk. They earn a stable income often based on long-term service contracts. MLPsoffer steady cash flows and consistent cash distributions.
2. The cash distributions of MLPs usually grow slightly faster than inflation. For limited partners, 80% to 90% of the distributions may be tax-deferred. Overall, this lets MLPs offer attractive income yields—often substantially higher than the average dividend yield of equities. Also, with the flow-through entity status (and the absence of double taxation), more capital is available for future projects. The availability of capital keeps the MLP competitive in its industry.
3. Further, for the limited partner, cumulative cash distributions could exceed the portion taxed at the capital gains rate once units are sold.
4. Limited partners' liability for an MLP's debts and obligations is capped at the amount of their capital contribution.
5. Until the 2017 tax cuts act benefit expires in 2025, investors can deduct 20% of their distributions from their taxable income, reducing the tax they would otherwise pay.
6. There are benefits to using MLPs for estate planning. When unitholders gift or transfer the MLP units to beneficiaries, both unitholders and beneficiaries avoid paying taxes during the time of transfer. The cost basis will readjust based on the market price during the time of the transfer if the transfer happens because of death. There is no step-up in basis if the MLP's units are gifted. Should the unitholder die and the investment pass to their heirs, the units pass tax-free, andthe fair market value is determined to be the value as of the date of death.

Disadvantages

1. MLPs are tax-efficient for investors but the filing requirements are complex. An MLP’s income, deductions, credits, and other items are detailed each year on an Internal Revenue Service (IRS) Schedule K-1 form that is sent to the investor. The K-1 can be complicated and create extra work for investors or the tax professionals they hire.
2. MLP investors are required to pay state income taxes on their allocated portion of income in each state in which the MLP operates, which can be more than one. This can increase their costs.
3. Another tax-related disadvantage of MLPs is that you cannot use a net loss (more losses than profits) to offset other income. However, net losses may be carried forward to the following year. When you eventually sell all of your units, a net loss can be used as a deduction against other income.
4. MLPs have limited upside potential. This might be expected from an investment that should produce a gradual yet reliable income stream over several years.

Examples of MLPs

Most MLPs operate in the energy industry. An energy master limited partnership (EMLP) typically provides and manages resources for other energy-based businesses. Examples might include firms that provide pipeline transportation, refinery services, and supply and logistics support services for oil companies.

Many oil and gas firms organize MLPs instead of issuing shares of stock. Using the MLP structure, they can both raise capital from investors and maintain a stake in operations.

Some corporations may own a sizable interest in their MLPs. They may also set up separate stock-issuing companies whose role is to own units of the corporation's MLP. This structure allows them to redistribute the passive income through the corporation as regular dividends.

MLP Returns

Many MLPs are listed in the Alerian MLP Index, the leading gauge of energy infrastructure MLPs.

The Alerian MLP Index measured an annualized five-year return of 6.2% for the period ending June 30, 2023. Electricity prices were in a slight upward trend over most of that period; however, with crude oil prices rebounding approximately 74% from 2022 to 2023, the Alerian MLP Index surged 30% over that three-year period.

An investor interested in buying MLPs could consider investing in a portfolio of MLPs that is diversified across sectors to reduce risk.

For example, Brookfield Asset Management, a leading global alternative asset manager with approximately $850 billion of assets under management, has MLPs in the real estate, infrastructure, and renewable energy sectors.

The Bottom Line

Master limited partnerships (MLPs) carry the tax benefits of private partnerships and the liquidity of publicly traded companies. MLPs are low-risk, long-term investments.