What Is a Master Limited Partnership?

As investors become more and more desperate to earn higher yields on their investments (especially those looking for more retirement income), they become more and more interested in MLPs – master limited partnerships. But what is a master limited partnership and is it a safe investment?

The Definition

MLPs are securities that are traded on the open markets just like stocks. They are mainly structured to produce high income and juicy tax benefits – a nice combination. Let’s dig a little deeper to understand exactly how these investments work.

Who can form an MLP?

Not every corporation can form a master limited partnership. In most cases, the firm must be in the natural resource business, and it must also be involved in extracting or transporting those natural resources. Real estate developers can form MLPs too, but most of the partnerships you’ll find are involved in the natural resource business.

How does a company qualify to be a master limited partnership?

The company must earn at least 90% of the income from producing, processing or transporting oil, natural gas or coal. This type of business formation was established by the Tax Reform Act of 1986. The intent of that law was to encourage energy infrastructure and development.

Who gets what?

Every quarter the investors (limited partners) receive a quarterly dividend. The general partners are the managers, and they determine how much that dividend is going to be. Most of the contracts between the limited partners and the general partners call for the general partners to earn more as the limited partners earn more. For that reason, the general partners have an incentive to keep those distributions high.

Tax benefits of a master limited partnership.

Because MLPs are a partnership, the dividends aren’t taxed twice as they are with corporations. This is the main reason why MLPs are formed. Investors also get to record a share of the MLPs’ depreciation, which is a huge benefit.

As sweet as those tax benefits are, if you own shares in an MLP directly you could be looking at a tax headache. The rules are super complex. If you buy shares directly, you might have to file a tax return in each state in which the MLP operates. Not only that, if you buy shares in a retirement account, you still might be required to pay tax on the income. Yuk.

That’s why there has been such an interest in buying MLPs through mutual funds and ETFs. The downside of buying MLP shares through mutual funds, however, is that the tax benefits disappear in many cases.

Still, there are a few ETFs and closed end funds that do have some of the beneficial tax benefits of owning a master limited partnership directly. With these shares, the distributions are considered a return of capital. That’s nice in the beginning, but it can be a nightmare after several years. If you buy MLPs like these, you better plan on holding those shares forever or until you die. If you sell the shares while you are alive, you will be subject to recapture. If you simply hold on to the shares until your death, there will be a step-up in basis to the then-current market value of the shares. So if you are young and healthy, this could be a problem. However, if you are old and sick, the MLP could be just what you’ve been looking for. You see, there really is always a silver lining. 🙂

There are also MLP exchange traded notes (ETNs). These are really very similar to bonds. The distributions are considered ordinary income and are taxed accordingly.

Built-In Safeguards?

Since these investments are based on distributing income, they are built around businesses that generate cash. Any failure to pay quarterly dividends by the general partner is a default and a very serious matter. That’s no guarantee, but it is a pretty attractive structural safeguard.

But when you think about safety, your primary concern has to be the safety of your capital.  Because many MLPs hold shares in oil related companies, they can clobbered if energy prices drop.  Look what happened to one such MLP in the last 6 months of 2014:

This MLP took a nose dive as energy prices tanked but they could also get beat up if the MLP suspends or reduces the dividend for other reasons.  Bottom line, you have to be willing to accept large dips in your capital if you buy MLPs.  That’s one reason why I don’t buy them.

Is an MLP for you?

Understand that because many people are desperately searching for higher yields, MLPs have exploded in popularity. The businesses themselves have been gobbling up competitors and fighting one another in bidding wars. That means investors might be overpaying for assets.

As you can clearly see from the discussion above, the world of Master Limited Partnerships is rather complex. I never recommend that you invest only for tax benefits, and this is no exception. The reason this is so important is because what Uncle Sam giveth, Uncle Sam taketh away. In fact, the tax law change in 1986 that created MLPs destroyed real estate limited partnerships, and many people lost a fortune in that period. This could happen again to MLP investors.

My best advice is to treat the MLP as you would any other investment. Yes, the high yield is great, but make sure the business is strong and can sustain those high-interest payments. High dividend stocks are risky. It’s critical that you understand how the MLP is earning the money they are paying you before you invest.

Have you invested in Master Limited Partnerships? What has been your experience?