Master Limited Partnerships

What Is A Master Limited Partnership?

Master limited partnerships (MLPs) are exchange-traded vehicles that invest primarily in energy and other natural resource projects, particularly oil and gas storage, transportation, exploration, development and pipelines. MLPs are popular with some investors for their very high yields, but they tend to track the price of oil, which means they can be volatile. Also, their share prices have been depressed in recent years, reducing their overall return.

Over the past decade or so, MLPs have yielded about 7% to 8%, or about four times the dividend rate on stocks in the S&P 500. However, the price of many MLP shares have dropped just as the price of oil has declined.^[1] MLPs also have complicated tax issues due to their structure.

Units, Not Shares

As the name suggests, MLPs are partnerships, not corporations, although they are publicly traded. MLPs have one general partner, which manages and administers it, and many limited partners, basically the shareholders. Instead of shares of stock, the limited partners own "units" in the MLP. The MLP basically acts as a pass-through vehicle that passes most or all of its profits and losses through to the limited partners.

As a result, unlike corporations, MLPs in the U.S. do not pay federal income taxes, which partially explains their high yields. Rather, the limited partners are required to file an annual Schedule K-1 with the Internal Revenue Service that shows their share of the MLP's income, gains, losses and deductions. They are then taxed at their individual tax rates. Investors may also need to file state tax returns in those states where the MLP operates even if they don't live there.^[2]

Tax Issues

If the MLP reports a net loss, the investor can't use that loss to offset gains elsewhere, as they can with other investments. Rather, the loss must be carried forward and used against future income from the same MLP. If there is any loss still remaining, the investor can deduct it against their other income but only after they sell their entire interest in the MLP.^[3]

In addition, an MLP will sometimes generate what is called "unrelated business taxable income," or UBTI. This can lead to a tax liability even if the MLP is held in a tax-deferred account, such as an individual retirement account (IRA).

In order to qualify for exemption from federal income taxes, at least 90% of the MLP's income must come from "qualifying income." This includes income and gains from energy-related activities, such as processing, storing, or transporting crude oil and natural gas.^[1]

Other Disadvantages To MLPs

MLPs are somewhat similar to real estate investment trusts (REITs), which own, develop and manage income-producing real estate properties and pay out most if not all their taxable income to shareholders. Many REITs diversify their holdings among a variety of property types and industries, including shopping malls, offices and commercial buildings, residential apartments, health care facilities, hotels and storage facilities. However, MLPs are generally tied to the oil and gas industry and offer little in the way of diversification. As a result, they tend to track the worldwide price of oil.

The amount of money MLPs actually return to unit holders is unpredictable. While most MLPs provide a forecast of how much they expect to distribute to their limited partners over the next 12 months, that amount is not guaranteed. Should that get reduced, it not only decreases the dividends investors can expect but also the price of the MLP's shares.^[1]

Summary

Master limited partnerships (MLPs) are exchange-traded vehicles that invest primarily in energy and other natural resource projects. MLPs pay very high yields, about four times the dividend rate among stocks in the S&P 500, but their share prices tend to be volatile as they generally track the price of oil. MLPs also have unique tax liabilities.