Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

A Guide To Master Limited Partnerships

A Master Limited Partnership (MLP) is a limited partnership (as opposed to a corporation) that is listed on a securities exchange.  This business structure allows the ownership of the firm (known as the general partner/s) to maintain complete control of the business, as opposed to being answerable to shareholders.  Further, MLPs receive favorable tax treatment due to their status as a partnership, which allows them to avoid paying corporate income tax by “passing through” profits as distributions to the limited partners.  To qualify for this favorable status, a company must derive at least 90% of its income from qualifying sources, mostly related to natural resources and infrastructure1.

pipes

MLPs have a structure similar to that of private equity investments2, with a General Partner (GP) and Limited Partners (LPs).  The GP is in charge of the operations of the partnership, but they generally only have a small ownership stake, usually around 2%.  The LPs are passive investors, and while they make up the majority of the ownership, they are subject to limited liability (not to exceed the size of their initial investment).  To encourage GPs to increase partnership distributions, many MLPs include Incentive Distribution Rights, meaning that the GP will receive an increasing percentage of distributable cash flows as per-unit distributions increase.  In other words, as the partnership generates higher distributable profits, a larger share of those profits will be paid to the GP.

Due to the above-mentioned structure, MLP holders (LPs) are able to realize favorable tax treatment.  The profits of the partnership are passed through to the LPs, as are several deductions and tax credits, causing the majority of MLP income to be tax-deferred.  As distributions are made, the tax-deferred portion reduces the investor’s cost basis, and (as long as the cost basis remains positive) that income is not taxed until the sale of the investment, at which time it is taxed at the capital gains rate.  After the cost basis is reduced to zero, any additional deferred income is taxed as capital gains in the year in which they are received.  Additionally, all non-deferred gains are taxed as ordinary income, as they would be with ordinary non-qualified stock dividends.  Because of this unusual tax treatment, MLP investors must file Form K-1 when paying taxes, as opposed to the standard form 1099.3  Investors are also subject to state income taxes in each state in which the MLP operates (depending on the portion of the income allocated to each state) though often times this is small enough to be negligible under state minimums.

While the favorable tax structure and high levels of current income provided by MLPs make them an attractive investment, they are not without significant risks as well.  Because MLPs are primarily in the natural resource and infrastructure industries, they are subject to sector-specific risk.  In addition, the high payout levels of MLPs make them subject to higher levels of interest rate risk than ordinary equities.  Another problem from the perspective of an investor relates to the different methods for accessing MLPs as an asset class. While most investors agree on the value of diversification, the standard vehicles for this in the MLP space (mutual funds, exchange traded funds, or notes) do not pass along the tax benefits of holding individual MLPs.  This means that in order to realize the tax advantages of MLPs, investors must either eschew diversification, or invest in a large number of individual MLPs, which could cause headaches during tax season due to the filing requirements.  Also, while individual MLPs can be held in traditional and Roth IRAs, depending on the amount of partnership income, investors can be subject to unrelated business income tax (UBIT), and might be required to file IRS Form 990T. Before investing in MLPs, both the reason for choosing the asset class and the preferred method should be carefully considered.

References
1. Frequent readers will note that this is not unlike REITs, which are described in detail here: http://www.empirical.net/real-estate-investment-trusts/
2. See our post on private equity for more details: http://www.empirical.net/introduction-private-equity/
3. This is an important consideration, as Form K-1 can be significantly more difficult and time-consuming to complete.

Tags: , , ,

About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

No comments yet.

Leave a Comment