One of the items of interest in the news today was an article explaining that the IRS is considering adjusting rules on Master Limited Partnerships (MLPs) to respond to their increasing popularity with investors. I was vaguely familiar with MLPs from working with various K-1s, but the article made me curious. What are they, who uses them, and what are their advantages?
The IRS recognizes four major different types of business entities: sole proprietorships, partnerships, S Corporations and C Corporations. Of these, sole proprietorship, partnership and S Corporation members all pay taxes on corporate activities through their personal tax returns, but the entity itself does not pay any taxes. C Corporations are taxed as separate entities, which means that the corporation pays taxes on any profits it generates, and then shareholders pay additional personal taxes on any dividends they receive from the company. This is referred to as “Double Taxation.”
MLPs are partnerships, and have the advantage of being publically traded without being subjected to double taxation. MLPs are only allowed in certain cases: at least 90% of a business’s income must come from energy production, natural resources, or real estate. Energy pipelines in particular have gravitated toward this form of ownership.
An MLP is managed by a General Partner, and then individual investors come in as Limited Partners, or unitholders. For both general partners and unitholders, income flowss to investors based on the operation’s cash flow, rather than its profitability, so it is quite possible to get both income payments and have a tax loss due to noncash expenses such as depletion and depreciation. Income losses for the partnership may be carried over to offset future profits from the same MLP. Distributions in excess of profits are applied to reduce an investor’s cost of buying into the company, so investors pay taxes on the excess distributions only as capital gains when they sell their share of the partnership.
Some of the advantages of the MLP include high yields, consistent distributions and the fact that the general partner’s compensation increases as the unitholder’s does. One of the major disadvantages is that they can make filing personal income taxes more complicated. MLPs have lower liquidity, so they can be more difficult to trade. They are not suitable for IRAs and other tax advantaged accounts. Additionally, an unpaid creditor can seek the return of distributions even after an investor has sold any units in the MLP if the investor held the units when the liability was incurred.
It is possible to invest in indirect investments in MLPs such as ETFs or mutual funds. These would avoid some of the drawbacks, such as the increased complexity to the individual investor’s income tax situaiton. However, they would also change the nature of the investment, which reduces the level of income the investor can expect from the MLP. Additionally, they may have high fees.
Some of the larger MLPs include Enterprise Products Partners LP (EDP), Energy Transfer Partners LP (ETP), Williams Partners LP (WPZ), Plains All American Pipeline LP (PAA), Magellan Midstream Partners LP (MMP) and Kinder Morgan Energy Partners LP (KMP). Two of the larger ETFs include the Alerian MLP ETF (AMLP) and the First Trust North American Energy Infrastructure Fund (EMLP).
This article is for information purposes only and should not be constituted as advice. MLPs can be profitable for some investors, but are a complex instrument. An investor interested in MLPs should proceed with caution and do lots of research before putting their money in any investment, including consulting with a financial advisor, planner or other expert.
Image courtesy of ddpavumba at FreeDigitalPhotos.net
References and Additional Reading:
Choose your Business Structure, from the US Small Business Administration
An Investor’s Guide to Master Limited Partnerships, on Fool.com
Master Limited Partnerships (MLPs), on DividendDetective.com
Master Limited Partnership (MLP), on InvestingAnswers.com
Michael Blum: ABCs of ETFs. on nasdaq.com
User’s Guide to Master Limited Partnerships. on Vanguard.com
Ways to buy MLPs, on Fidelity.com