Developed in the 1980s, a master limited partnership (MLP)–sometimes known as a publicly traded partnership (PTP)–is generally a limited partnership that operates an active business. An MLP offers interests (known as “units”) that are traded, much like shares of stock, on an established securities market, or that are readily tradable on a secondary market or its substantial equivalent (for more information, see the technical tip under “How does an MLP work?”). When you purchase an interest in an MLP, you technically become a unitholder rather than a shareholder. In this respect, it is different from a private limited partnership.
An MLP typically has a two-tiered structure: (1) a general partner (in some cases, multiple general partners) that manages the day-to-day operation of the business, and (2) limited partners whose investments provide the partnership with capital and who receive income from the operation in return.
Despite the name, an MLP may be structured as a partnership but taxed as a corporation. Some MLPs are actually publicly traded limited liability companies (LLCs) that have chosen to be taxed as a partnership and do not have a general partner. An MLP may also represent a smaller piece of a corporation that has been spun off as an MLP for which the corporation is the general partner (in some cases, the general partner also may increase its percentage of ownership by holding limited-partner units). Though the differences may seem like technicalities, they are actually important, because partnerships and corporations are taxed differently.
Corporate earnings are taxed at the corporate level and again as part of an individual investor’s income if paid out to shareholders as dividends. By contrast, MLPs that are considered a partnership are not treated by the tax code as a business entity but simply as an aggregation of all of the individual partners involved. Therefore, an MLP pays no tax at the partnership level; each individual unitholder pays tax on his or her proportionate share of the earnings. As a result, because a partnership is not subject to taxes at the partnership level, it becomes a “flow-through” entity that is able to pass on more of its earnings to individual investors. That can make it attractive to individuals seeking an income stream. Limited partners also receive benefits such as deductions and depreciation allowances, which would normally be applied at the corporate level.
As of 1987, the tax code requires a publicly traded MLP to receive 90 percent of its income from specific qualifying passive sources, including natural resources such as oil and natural gas, real estate, or commodities, in order to qualify for tax treatment as a partnership. If it does not, it is taxed as a corporation and therefore owes taxes as a business entity. Because of this restriction, most MLPs now are in energy-related businesses (for example, those involved in exploration, development, production, mining, refining, marketing, and transportation of oil and gas, minerals, geothermal energy, timber, and alternative fuels such as biodiesel); oil and gas limited partnerships and real estate tax credit limited partnerships are particularly common. Some exchange-traded funds (ETFs) also are legally structured as MLPs.
Income sources that count toward the 90 percent requirement for qualifying passive income and tax treatment as a partnership include:
Tip: Several qualifications and limitations apply. For more information about this exception, consult a tax expert.
Technical Note: An MLP that traded prior to 1987 but whose income was not derived from any of the sources that meet the definition of qualifying passive income for treatment as a partnership could choose to continue to be taxed as a partnership if it paid a 3.5 percent annual tax on the partnership’s gross income from the active conduct of its trade or business. However, relatively few MLPs still trading fall into this category. For more information about this, consult a tax expert.
As noted above, an MLP typically has both a general partner and limited partners. Most individual investors who buy units in an MLP become limited partners; however, if the general partner is a publicly held corporation, investors may buy shares of stock in it just as they would any other corporation. MLPs must register with the Securities and Exchange Commission and provide investors with a prospectus and other disclosures.
MLPs typically make cash distributions to limited partners quarterly, which are reported to each partner on a K-1 form (rather than the 1099 form used for corporate dividends). These cash distributions represent a proportionate share of the partnership’s distributable cash flow, which includes not only income from the MLP’s operations but also depreciation, depletion allowances, tax credits, and other tax deductions. The K-1 will specify each partner’s share of income gain, loss, deductions, and tax credits for that tax year.
Unlike corporate dividends, an MLP’s cash distributions are considered a return of capital and used to adjust the individual partner’s cost basis when the units are sold. At that point, the portion of the sale proceeds that results from adjusting the cost basis downward by the amount of the accumulated distributions, deductions, and depreciation becomes taxable as ordinary income, while the remaining portion is taxed at the capital gains rate.
Since depreciation and deductions can offset or even eliminate current tax liability on the cash distributions–and many MLPs attempt to make sure that their quarterly distributions exceed any tax owed–an MLP can in effect provide tax-deferred income.
Some MLPs focus on rapid growth; others offer slower growth but more reliable cash distributions. Also, an MLP may have an anticipated duration, which will be detailed in its prospectus. Although the lifespan will typically run anywhere from 5 to 15 years, the general partner can decide when to liquidate. Although MLP units are certainly more liquid than private limited partnership shares, you should be prepared to hold on to them for a number of years, or risk selling at a loss. The MLP’s organization, business strategy and objectives, potential risks, fees, and anticipated duration, as well as other important information, can be found in the prospectus available from the partnership, which you should read and consider carefully before investing.
State law and the partnership agreement will govern the limited partnership. The partnership agreement should contain, among other things, the amount of each partner’s distributive share of partnership profits and losses. In cases where the partnership agreement fails to address an issue, state law will dictate how the partnership is to operate.
Technical Note: A partnership will be treated as readily tradable on a secondary market or the substantial equivalent thereof if the partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market. This occurs in several cases, including if (1) partnership interests are regularly quoted by any person making a market in the interests (i.e., a broker/dealer), or (2) an investor has a readily available, regular, and ongoing opportunity to sell or exchange the partnership interest through a public means of obtaining or providing information of offers to buy, sell, or exchange interests in the partnership. However, interests in a partnership will not be treated as readily tradable on a secondary market or the substantial equivalent thereof unless (1) the partnership participates in the establishment of the market or the inclusion of its interests thereon, or (2) the partnership recognizes transfers made on that market. For more information, see Internal Revenue Code Reg. 1.7704-1(d) and consult a tax expert.
An MLP that qualifies for taxation as a partnership does not owe taxes at the partnership level. As a result, it may pass on a greater share of its earnings to the limited partners (i.e., individual investors). Also, the tax advantages of distributions being treated as return of capital can mean a higher immediate net yield, particularly for higher-income investors, than if those distributions were taxed as ordinary income in the year received.
Private limited partnership shares often require a steep initial investment. By contrast, units of widely traded MLPs may be much more affordable for the average investor. Also, because MLP units are traded on an established securities market or are readily tradable on a secondary market (or its equivalent), they are more liquid than private limited partnership shares. This is an advantage if you no longer wish to be a partner (for whatever reason), or if you have an immediate need for cash.
The absence of taxes at the partnership level makes it easier to use relatively inexpensive capital to pursue business opportunities.
Standard & Poor’s Corporation rates a number of limited partnerships. In addition, several firms analyze limited partnerships and rate such factors as the offering terms. This information permits comparison of limited partnerships and can lead to a more informed investment decision.
In general, limited partners are liable for partnership liabilities only to the extent of their capital contributions to the partnership, including any contributions you may have agreed to make in the future.
The safety of your principal depends on the type of limited partnership and quality of its holdings. Programs aimed at high capital gains involve commensurate risk. For instance, with oil and gas MLPs, there may be risk as to whether oil or gas will be found at all, and, if found, whether the source will dry up sooner than expected.
Brokerage commissions and other front-end costs can reduce the amount available to be invested, and there also may be additional management fees.
With many MLPs, if cash distributions increase over the years to certain specified levels, the general partner’s share of the cash distributions also grows. That means the limited partners may not participate as fully in the growth of the business as the general partner does. The general partner has an incentive to increase the distribution, but such growth can also gradually reduce the incremental benefit for the limited partners.
Example(s): ABC Energy Corp. is the general partner of the XYZ Master Limited Partnership, which owns pipelines used to transport natural gas. According to the partnership agreement, ABC receives 2 percent of the MLP’s cash distribution, while the remaining 98 percent is distributed proportionately among the limited partners. However, once the MLP’s distribution reaches 30 cents per unit, ABC’s share of that distribution is increased to 25 percent. And according to the agreement, if the distribution reaches 50 cents per unit, ABC is entitled to 50 percent of the distribution. That can cut into the return for the limited partners. By the same token, if the distribution were to decrease from 50 cents per unit to 25 cents, the general partner would feel the impact more dramatically than the limited partners.
In some cases, MLP general partners have been accused of making acquisitions simply to reach the threshold at which the general partner’s percentage of the cash distribution increases, rather than because the acquisition truly benefits the limited partners’ return.
Because limited partners generally have no voting rights and cannot play an active role in the management of the partnership, much depends on the integrity and management ability of the general partner. And though there are limits on a limited partner’s liability for the obligations of the MLP, they are not fully protected against the MLP’s creditors in the way that corporate shareholders are.
Because each unitholder is responsible for paying a proportionate share of the MLP’s taxes, tax issues can become complex, especially for larger unitholders who could be required to file returns in the various states in which the partnership operates.
In the past, individual investors have been the primary market for MLPs; many institutional investors (such as pension funds) cannot hold MLPs without running into tax complications and have either avoided or been prohibited from investing in them. Because institutions represent such a large percentage of the investing universe, that lack of institutional demand reduces the total potential demand for MLP units and could possibly affect liquidity.
Investing in an MLP through a tax-advantaged retirement account can negate the tax benefits of owning an MLP–for example, the tax deferral provided by cash distributions–because a retirement account is already tax deferred. Also, if an MLP’s pass-through income is high enough–over $1,000–it can potentially subject the retirement account to the “unrelated business income tax” (UBIT) on that income (see “Tax considerations” below).
Higher interest rates can affect the value of an MLP’s units, much as they do bonds. Bond prices tend to sink if higher interest rates make a bond’s fixed interest payments less attractive; the value of an MLP can experience a similar reaction. Also, an energy-related MLP can be sensitive to changes in commodity prices.
Investors purchase shares in an MLP through a securities broker-dealer or a financial planner. Offerings frequently involve suitability rules requiring that individuals meet minimum net worth, income, and tax bracket criteria. As an investor, you should be aware that many limited partnerships intend to dispose of their holdings within a specified period (often 7 to 10 years) and distribute the proceeds as capital gains to investors.
If an MLP is characterized as a corporation for federal income tax purposes, its income is taxed at the business entity level, and taxed again at the individual partner level when the earnings are distributed as dividends. In such a case, individual MLP investors are unable to take certain tax benefits, such as depreciation, deductions, and tax credits, on their own tax returns. Losses are not passed through to the partners, but are used as net operating loss carryovers by the partnership. Investors in an MLP should be sure they understand the tax implications of their choice.
An MLP that is taxed as a partnership is treated by the tax code in much the same way as a private limited partnership. Both private limited partnerships and MLPs that are not taxed as a corporation are subject to the passive activity loss limitation rules. That means that on their personal income tax returns, the limited partners are able to deduct their share of partnership losses only if they have passive gains from another investment to match against them. Investment income, such as interest or dividends from stocks or bonds, is not considered passive income, and losses from an MLP cannot be used to offset them.
Example(s): Assume Hal invests $20,000 in a newly organized private limited partnership. This is Hal’s only passive investment. At the end of the year, the limited partnership suffers an operating loss, $2,000 of which flows through to Hal as a limited partner. Because Hal does not possess passive income from another source, he cannot utilize the loss on his federal tax return this year. Nevertheless, Hal may carry forward the unused loss to offset passive income in future years.
Assume, now, that the above partnership was an MLP taxed as a corporation. Hal would not be subject to the passive loss limitation rules. Nevertheless, he would not be allowed to take a $2,000 loss on his personal income tax return, because the net operating loss would not flow through to the limited partners.
MLPs are also subject to the at-risk rules, which limit a partner’s share of losses in a partnership to his or her financial risk therein. (MLPs that are taxed as corporations are not subject to the at-risk rules.)
Your cash distributions are treated as a return of capital and therefore can lower your cost basis when you sell your units. However, they cannot reduce your cost basis below zero. Once your cost basis for the MLP reaches zero, any future distributions will be taxed as capital gains for the year in which they are received.
The Internal Revenue Service requires a tax-exempt institution or account to pay tax on income that is not directly related to the purpose for which it is considered tax exempt. This provision of the tax code is known as the “unrelated business income tax” (UBIT). When an MLP passes through its income directly to the limited partners without being taxed at the partnership level, that income is considered to be earned directly by each individual partner.
When a retirement account includes units of an MLP, the tax code treats the account as the unitholder. That makes it subject to the UBIT on the retirement account’s share of the MLP’s taxable business income (minus any deductions or depreciation reported on the K-1). A $1,000 deduction can be taken for the first $1,000 of the account’s net income from the MLP, but the remainder will be subject to the UBIT. (However, the UBIT does not apply to any capital gains realized when units are sold.) The decision about where to hold an MLP should be reviewed carefully for its tax implications.
This information, developed by an independent third party, has been obtained from sources considered to be reliable, but Raymond James Financial Services, Inc. does not guarantee that the foregoing material is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investments mentioned may not be suitable for all investors. The material is general in nature. Past performance may not be indicative of future results. Raymond James does not provide advice on tax, legal or mortgage issues. These matters should be discussed with the appropriate professional.