Introduction to Mastering Master Limited Partnership, Benefits & Risks

 

What is a Master Limited Partnership?

When considering a master limited partnership (MLP), there are a number of variables. This type of partnership is a limited partnership that is publicly traded on a securities exchange. An MLP provides several benefits for those involved; mainly it allows those in the partnership to get the tax benefits of a limited partnership while gaining the capital of publicly traded securities.

Two Types of Partners

There are two types of partners in a master liability partnership: the person who is considered the "limited partner" puts up the money for the partnership and then receives installments of income, usually quarterly, as it comes in via the cash flow of the company. This responsibility may fall to one person responsible for the capital, or a group of people who are able to front the money. The other type of partner is a “general partner” who is responsible for managing the MLP. They take care of the day-to-day responsibilities of the company and are paid according to how the venture performs.

Owning Stock in an MLP

The general partner and limited partner or partners - often called unitholders - have different implications than people who hold stock in a typical, publicly-traded company. For example, the master limited partnership income isn't taxed as an entity, but rather the income is distributed to both types of partners. This helps the partnership and the people involved avoid double taxation, which is a problem that many publicly-traded corporations face. Because the income isn't taxed twice, this means that shareholders - or "unitholders" receive a higher payout from their investment.

Tax Benefits

As mentioned above, MLPs avoid double taxation which most other types of public companies face. This is because these types of partnerships receive tax exemptions from the government if they meet certain stipulations. One of the rules is that 90% or more of the income of the MLP has to come from "qualifying sources" which are specific genres of business and are typically relegated to "natural resource activities" like natural gas processing, refining, transportation, storage and marketing. Individuals who hold units of an MLP will receive information on their income from the partnership and how to file income with their taxes each year.

Regulation of an MLP

MLPs are typically regulated by the general partner and the board of directors. The limited partners, or unitholders, aren't typically invited to meet together, like shareholders of a company might be invited to do. Additionally, limited partners don't usually elect the directors or the general partner. Instead, the general partner is incentivized to manage the MLP in such a way that the partnership thrives and increases its revenue over time. These incentives come in the form of larger returns as the partnership grows and makes more money.

MLPs are a unique way in which to earn income and hold shares without participating in a typical publicly-traded company. The tax benefit makes it very attractive for the partners involved.

Reaping Master Limited Partnership Benefits

The main benefit of a master limited partnership (MLP) is that the income from the organization is not taxed twice. Most publicly-traded companies are taxed on the income they make, and then again when that income is distributed to the shareholders. However, that is not the case with a master limited partnership. Those involved – usually called unitholders – only pay income taxes on the shares.

Taxation Benefits of a Master Limited Partnership

Although publicly-traded, MLPs are exempt from paying taxes at the entity level. This is a benefit extended only under certain circumstances; in other words, not just anyone can form an MLP. Rather, specific criteria must be met in order to get master limited partnership benefits. The partnership receives the corporate tax exemption if more than 90% of the organization's income is generated by certain sources. These sources usually include natural resource-related activities like petroleum, natural gas, transportation, and even some real estate endeavors.

Organizational Differences of a Master Limited Partnership

Additionally, those involved with the organization are typically one of two types of partner: a limited partner who provides the capital and receives quarterly payouts, and the general partner who manages the MLP and is compensated accordingly. As such, master limited partnerships are governed by a board of directors and the general partners. Unitholders don't vote to elect these members, but rather the members and general partners are tasked with increasing the partnership's revenue in order to generate a higher payout for all involved.

Differences that Translate to Benefits

These above-mentioned differences mean that being a partner in an MLP has distinctive advantages. The only time a unitholder of an MLP generally pays taxes is when they sell their unit, and must then pay regular income tax on the difference between the purchase price of the unit, and the current tax basis. There is also a potential to pay a capital gains tax on the amount by which the units appreciated since they were purchased. Unitholders of an MLP will receive specific instructions on how to declare incomes from these investments.

Who Can Buy into an MLP?

Since they are publicly traded, just about anyone can buy into master limited partnership benefits, which can be a wise choice for those looking to invest in the stock market. They can be a good investment as they have many of the same benefits as owning your own business. Additionally, MLPs often generate between 7% and 8% in dividend yields, most of which is tax-deferred. For larger partnerships, it's not uncommon for 70% or more of the dividends to be tax-deferred.

As with any investment strategy, it's smart to consult with various resources, including finance professionals, before making a decision about a master limited partnership. However, master limited partnership benefits can be a great resource, and often more lucrative and stable than typical stocks. Be aware of the differences between the two, however, as well as how to correctly pay taxes on the dividends when needed.

It is Important for Businesses to Understand Master Limited Partnership Risks

The publicly-traded master limited partnership (MLP) is a $100 billion dollar market that frequently provides returns on investments upwards of seven percent or more. Because master limited partnerships qualify for corporate tax exemptions, they don't pay taxes on corporate earnings, which can make them very attractive to investors. However, there are some master limited partnership risks of which investors should be aware.

Restrictions on What Constitutes and MLP

Of course, not just any company or corporation can decide to become a master limited partnership. There are strict regulations on what type of organization is eligible for this status and these stipulations typically include only companies that do business in natural resources such as natural gas. In some cases, real estate companies may qualify as well. Because MLPs are typically restricted to natural resource endeavors, the cost of doing business can fluctuate depending on the market cost of these resources. However, since most gas partnerships, for example, are in the pipeline business, this volatility may not extend to their unit price.

How Will MLPs Expand?

Another concern about potential master limited partnership risks is related to how quickly and efficiently an MLP will be able to increase its earnings. The general partner in an MLP – the person who runs the partnership – is incentivized to increase revenue, but in the wake of the stock market collapse and continued downturn, investors and advisors are worried that these partnerships won't be able to raise the money they need to expand. For example, the companies may not be able to get the loans they need due to tighter regulations, or investors may not have as much capital to invest – potentially leading to the partnership shutting down.

What will the Demand be Like?

Another concern related to the downturn in the economy is that the demand for these companies simply won't be there. As people continue to cut back on things like transportation cost and general consumption, these master limited partnerships may not see the expansion that is necessary to keep the cash flow coming to their unit holder's accounts, in which case the companies could go under, or simply limp along without providing the needed return on investment.

Investors are Liable for an MLP

Although investors gain many benefits from the taxation laws associated with a master limited partnership, they are also more liable for the company. Because all unitholders are considered “partners,” they are in theory held accountable for what happens to the partnership. However, in U.S. legal custom, unitholders have never been held financially responsible for an MLP's downfalls, when and if they do occur. Never the less this is a theoretical possibility to keep in mind, as partners in an MLP are not protected the same way corporate shareholders are.

MLPs are attractive investment strategies and there are many benefits to this type of investment. However, there are also master limited partnership risks which can emerge only after the investment has been made. It's wise to know of the potential for these risks before making an MLP purchase.

Master Limited Partnership and Taxation

Master limited partnerships (MLPs) are loved by investors for their low tax rate and relatively high dividend yield. MLPs are typically energy companies that have tax-exempt status under a law created during the administration of President Reagan. Because they are required to pay out most of their earnings to their stockholders – or unitholders, as they're known – returns are often high, though there are taxation rules to consider.

Avoiding Double Taxation

When looking at master limited partnership and taxation rules, one of the things investors love to point out is that MLPs don't pay federal income taxes on their earnings. Therefore, they have more cash in the bank that they are then required to distribute to their unitholders. Unitholders don't have to pay taxes on their shares until they sell, which means that investors get more money for their return, thus avoiding double taxation which often draws the value down.

Paying Taxes on MLPs

Most of the earnings from an MLP are not taxable until the investor sells. However, there are still rules about master limited partnership and taxation requirements that may mean the investor pays taxes in the year the unit was received. Usually, 75 to 85 percent of master limited partnership distributions are labeled as the return of capital which deems the unit not taxable until sale. That remaining 15 to 25 percent is considered a return on capital which can be taxable the year it was purchased. If that return on capital distribution is more than $1000 per year, the investor may owe taxes on any amount above that thousand dollars.

MLP Accounting

As made obvious above, accounting for rules involving a master limited partnership and taxation can be complicated, and are often more intricate than those of normal corporate stock. An MLP will mail a K-1 tax form to each person holding a unit of the partnership, prior to tax season of each year, which will help illuminate how the year's payouts need to be treated. This is often helpful to unitholders in determining how to claim their earnings on their tax returns, although it's never a bad idea to consult a tax or investment professional for further help.

Losing the Tax Exempt Advantage

Master limited partnerships are set up so they don't get taxed on corporate profits, but this saving may be negated if investment accounts aren't set up correctly. For example, if the investor keeps the MLPs in a tax-deferred personal retirements account, they will still have to pay regular income tax on the distributions taken. Additionally, if the MLP creates what's known as unrelated business taxable income, the investor will have to file a separate tax return and pay taxes that stem from these assets.

Master limited partnerships can be an important part of an investor's portfolio, especially when building a retirement account. Their tax-exempt status is helpful, yet there are still many things to be considered when investing in MLPs.

 F A Q

The History of Master Limited Partnerships

MLPs were created in 1981 to allow certain business partnerships to issue publicly traded ownership interests. The first MLP was Apache Oil Company, which was quickly followed by other energy MLPs, and then real estate MLPs.

Are MLPs undervalued?

In fact, MLPs are undervalued based on virtually any fundamental metric. For example, the group trades at an EV/EBITDA multiple of 8.2-times, well below its 3-year average of 10.5-times and its 10-year average of 11.6-times.