Have you ever heard of a Master Limited Partnership (MLP)? As background, an MLP is a limited company that is publicly traded on a stock exchange such as the New York Stock Exchange (NYSE) or NASDAQ. Because of their public listings, MLPs combine the tax benefits (more on that later) of a limited company with the liquidity of publicly traded securities. Some investors may have “fears” of companies in general; It is important to know that MLPs are regulated by the Securities and Exchange Commission (SEC) and must comply with Sarbanes-Oxley, just like other publicly traded companies. These terms are attractive to investors as they mean that MLPs file annual and quarterly returns, notify investors of any material changes affecting the business, and are required to use enhanced accounting rules as enacted by Congress.
According to the National Association of Publicly Traded Companies, the MLP structure is limited to companies that receive 90% or more of their income from interest, dividends, real estate income, proceeds from the sale or disposition of real estate , income and earnings from raw materials. or futures of raw materials, and income and gains from activities related to mineral or natural resources. While there are some exceptions, the vast majority of MLPs operate in the energy industry. The focus on the energy industry stems from a section of the US tax code that states that MLPs must operate in certain industries, most of which are relevant to the use of natural resources (read: oil extraction and transportation and natural gas).
Benefits and tax considerations:
While MLPs are listed on stock exchanges like the NYSE, American, and NASDAQ just like companies like General Electric (NYSE-GE) and Microsoft (NMS-MSFT) do, the big difference is that because MLPs are not corporations , do not pay corporate tax. This “tax quirk” contrasts sharply with the experience of a corporation’s shareholders (most corporations) facing double taxation: paying taxes first at the corporate level and then at the personal level when those earnings are received as dividends. the owners of a partnership pay taxes only once, at the individual level. Because MLPs do not pay corporate taxes, all of the tax elements are passed on to the partners, which in theory leaves more of the MLP earnings available to distribute to the owner of the unit (you). Also, for most of the time you hold your MLP position (units), you may not have to pay taxes on distributions like you do on corporate dividends. Specifically, distributions are considered a tax-deferred “return of principal,” that is, a distribution that reflects a return on your initial investment. As you receive “return of capital” distributions, you reduce the tax base of your partnership units. And these disbursements are not taxed as current income. In addition, the unit owner (investor) may also recognize a prorated portion of the MLP’s depreciation on their tax form that serves to reduce the unit owner’s tax liability.
Although the tax advantages of MLPs are very attractive, there are some potential drawbacks. One of the disadvantages of MLPs is that you are responsible for paying taxes on your share of the partnership’s taxable income. Dividends paid to shareholders by corporations are considered “qualified” and therefore taxed at a lower tax rate of 15%. This is not the case for cash distributions paid by MLPs. However, cash distributions often exceed the partnership’s taxable income, which can negate the “net” impact of taxable income. Another consideration in owning MLP is that your personal “tax complexity” generally increases. Specifically, filing taxes can be more complex than investing in common stock because you will receive the partnership’s Schedule K-1 instead of a 1099. The K-1 will reflect your share of the MLP’s income and losses and should be reflected on your tax return. And for unit holders with significant positions, there is the potential to hit state thresholds (your tax advisor can help you identify the thresholds) that will require you to file tax returns in the various states in which the partnership operates. Finally, MLPs may not be attractive in tax-deferred IRAs because the partnership may generate taxable income in any given year. Tax considerations for institutional investors limit their participation, and mutual funds have been slow to invest in MLPs. Consequently, the pool of potential investors is limited and may reduce the liquidity of unitholders. At the time of sale, units may be worth more or less than their original cost.
Please note that the “tax considerations” listed above are not exhaustive and are for informational purposes only. Therefore, you should carefully consider the pros and cons of investing in MLPs and consult your tax advisor to fully determine the tax implications of any investment.
In conclusion, MLPs can be a solid option for income-oriented investors, as most offer very attractive returns that typically fall in the 5-7% range. In addition, such returns usually receive favorable tax treatment. As with most tax-friendly investments, there are some “tax gripes” associated with MLPs; however, for some the advantages far outweigh the disadvantages. In general, although MLPs are not well understood, they can be one of the most tax efficient vehicles available to the investing public. And while there are some exceptions, the vast majority of MLPs operate in the energy industry. Because MLPs tend to be involved in the energy field, when one considers becoming a unit owner, the question arises where do you think energy prices will go in the next ten years? The next twenty years? Higher or lower? Good luck!
