Master Limited Partnerships

A master limited partnership (MLP) is a publicly traded partnership (PTP) or limited liability company that elected to be taxed as a partnership that combines the tax benefits of the limited partnership with the liquidity of publicly traded securities. Interests in the MLP are sold as MLP units, which can be traded on the NASDAQ, New York Stock Exchange, and, to a lesser extent, other exchanges. Their main investment advantage is that they pay a high income that is only partly taxed when received; the remaining portion is tax-deferred until the units are sold. Like all limited partnerships, MLPs have a general partner, which can be an individual, corporation, or even another partnership, that provides the expertise and labor of running the partnership, and limited partners who contribute only capital, their liability limited to the amount of their investment. Investors who buy the MLP units become limited partners, or unitholders, of the partnership. The National Association of Publicly Traded Partnerships is the trade association for MLP sponsors, who set up the MLPs and sell the MLP units in an initial public offering.

MLPs Are Active Businesses

Most traditional limited partnerships — and even some PTP's, such as commodity funds, and oil and gas royalty trusts — are investment funds rather than true businesses. By contrast, most MLPs are active businesses that focus mainly on the infrastructure to provide energy products or other natural resources, although some focus on real estate or private equity. Nonetheless, most investors in an MLP are limited partners, where the deductibility of losses is limited by at-risk and passive loss rules. A sample of the type of businesses that MLP businesses engage in include the following:

As a partnership, MLPs are pass-through entities, passing whatever income is earned and whatever deductions, tax credits, and some other tax items that can be claimed to the partners. The MLP itself is not a taxable entity; so a main advantage of an MLP is that it can pass more of its cash flow to the limited partners. However, to remain a nontaxable entity, the businesses that MLPs can engage in is restricted by the tax code. To promote the development of infrastructure for the production, transportation, and storage of energy and other natural resources, the Tax Reform Act of 1986 restricted the favorable taxation of MLPs to those that earned what the tax code refers to as qualifying income (IRC §7704), which is income earned from certain energy industries and certain types of passive income, such as real property rents, and from commodities or commodity futures. For each tax year, 90% of the income earned by an MLP must be qualifying income; otherwise, the MLP will be taxed as a corporation. However, qualifying income is not earned from businesses dealing with natural resources that are abundant, such as soil or water. The resource must be depletable (IRC §613).

Primarily because of tax code requirements and the need to generate steady income to pay for distributions, MLPs focus on real estate, energy, and natural resource businesses that would allow the MLP to pay regular quarterly cash distributions. MLPs tend to operate in slow-but-steadily growing parts of the energy industry that can produce steady cash flows but have limited growth opportunities. Although MLPs tend to focus on the infrastructure of energy and commodity production, MLP unit prices do not necessarily follow the prices of the energy or commodity handled by the MLP. Indeed, sometimes MLP units will fall in price when the related energy or commodities are rising, and vice versa. However, prices of MLP units based on upstream businesses, such as exploration and production, or downstream businesses, such as distribution, will fluctuate more with the underlying commodity than midstream businesses, such as pipelines and storage, that rely more on long-term contracts for most of their income.

An MLP can be started in various ways. An MLP, of course, can be started as an MLP, but many times, an MLP will be carved out of a previous business. A PTP may convert to an MLP or a non-traded partnership may go public. Several private partnerships may roll up into a single MLP or a corporation may spin off, or roll down, some assets into a separate MLP in which it maintains a stake with the hope of recognizing a greater value from the spinoff.

Investment Characteristics

MLPs sell partnership units and the owners of these units, the limited partners — are referred to as unitholders. Typically, the limited partners own about 98% of the business while the general partners own the remaining 2%.

MLPs yield a higher return than most other securities bought for their income. From 2003 to 2013, MLPs earned an average annualized total return, which includes the income plus changes in unit pricing, of 16%, compared to about 7% for stocks and 6% for bonds over the same period. As a further advantage, their higher yield is only partly taxable when received, since a major portion of the distribution consists of an allocation of deductions, losses, tax credits, and a return of capital.

MLPs are 1st sold as an initial public offering; thereafter, the units are sold on exchanges or in the over-the-counter market. MLPs also have some inflation protection, since they can generally pass their price increases to their customers. However, many of the prices are regulated by the Federal Energy Regulatory Commission (FERC).

The value of MLPs is not closely correlated with stocks, thus providing some degree of diversification. However, because they are purchased mostly for their income, they are subject to interest rate risk in 2 ways. The 1st portion of interest rate risk can be attributed to changes in the value of the MLP units because of changes in the interest rate, much as bond prices vary inversely with interest rates. As interest rates rise, then the MLP units must compete with other investments paying higher interest. The 2nd effect that interest rates have is on leveraged MLPs: higher interest rates will increase interest expenses for the business, reducing profits.

Prices of MLP units are quoted in the same way as common stocks, showing the following information:

 MLP Funds

MLPs can also be bought as an exchange-traded fund, as an MLP exchange-traded note, or as an open-end mutual fund. However, the benefit of directly owning MLP units rather than shares in an MLP fund is that a sizable portion of the quarterly distributions is treated as a return of capital, thus deferring taxes until the sale of the units. Additionally, MLP distributions are not subject to the 3.8% Medicare tax on net investment income.

Investing in MLP funds does have the advantage of simplifying taxes, in that the taxpayer will receive a Form 1099 instead of the more complex Form K-1. However, there are several disadvantages:

MLPs can also be held as MLP I-Units, issued by a publicly traded corporation specifically formed to hold MLP units. Distributions to investors are in the form of more units rather than cash, thus deferring any tax on the distribution until the distributed units are sold.

Benefiting from MLPs through a Closed-End Fund

Most investors who do not want to own MLPs directly can benefit from MLPs best by owning them through a closed-end fund (CEF). Putting a CEF wrapper around a portfolio of MLPs makes a lot of sense. Investors in the CEF get nearly all of the benefits of direct MLP investing without the tax administration headaches. However, the CEF represents an extra layer of expenses and decision-making. The CEF's income may not be solely derived from MLP distributions and could include dividends and interest income from other sources. However, MLP CEFs are no different from other CEFs when tax season arrives. The distributions are broken down into the typical 3 categories:

  1. net investment income, for cases where an MLP in the fund's portfolio actually pays a dividend or the fund receives income from non-MLP sources
  2. net realized capital gains, stemming from CEF portfolio management decisions to sell some assets
  3. return of capital, accruing from the portfolio MLPs' distributions that are passed through to the fund's own investors.

For each tax year, investors are liable for taxes on the net investment income and realized capital gains, but the return of capital reduces their cost-basis, so the return of capital portion is not taxed until the CEF shares are sold.

This is also the reason that most MLP CEFs trade at large premiums to their reported net asset value (NAV). When the CEF receives a return-of-capital distribution from an MLP in its underlying portfolio, it too must write down its cost basis for that MLP. Deferred taxes come into play, and often MLP CEFs have very large deferred tax liabilities. Such liabilities, by definition, lower the reported NAV, even though some of those deferred liabilities may never actually be recognized. Astute investors realize all of this and are willing to pay more than the reported NAV for the fund. This is another example of why the relative discount/premium of CEFs is more important than the absolute discount/premium.

Disadvantages of MLPs

A major disadvantage of MLPs is that distributions are considered to be a form of passive income as defined under IRC §469. Because MLPs are publicly traded partnerships, passive losses from an MLP can only be deducted from income earned from that same MLP. It cannot be deducted against other income, not even other passive income, until the MLP units are finally disposed of. So passive losses from an MLP must be carried forward to future tax years until the MLP earns sufficient income to offset the losses. Thus, a primary consideration for any would-be investor of MLPs is how long the MLP will sustain losses and when is it likely to become profitable. Investors should also consider how much debt for which they would be personally at risk.

The biggest risk for an MLP is that it fails to make the required quarterly distribution, which is a form of default, similar to when a bond issuer misses an interest payment. Anything that causes cash flow to decline, such as losing customers, natural disasters, or price competition, increases the risk of default, which will reduce the price of the MLP units in the secondary market.

Another disadvantage of MLPs is that funding is limited. MLP units represent a percentage ownership of the partnership, so no more than 100% of the interest can be sold, thus limiting growth. A corporation on the other hand, can issue more stock to obtain more funding.

Large unitholders of MLPs may have to file tax returns for each of the states in which the partnership does business.

Institutional investors, such as pension funds, generally do not buy MLPs because they may incur unrelated business taxes on the investments, thus lowering potential demand for MLPs.

MLP Evaluation

The value of MLPs is measured by their distribution rate, which constitutes the main investment return component, and whether or not it is increasing. MLPs that are increasing their distributions are generally favored to continue being able to pay the distribution. Financial ratios commonly used to evaluate stocks, such as unit prices to earnings, cash flow, and book value, can also be used to compare different MLPs.

When evaluating master limited partnerships, an investor should look at the distribution track record, noting whether distributions have been increasing or shrinking, and the source of the distributions. Sometimes, an MLP will incur debt or use capital to maintain the distribution rate. However, borrowing or using capital to pay distributions cannot continue indefinitely. Do not necessarily buy MLPs with the highest yield. Rather, MLPs should be selected for their potential for growth, so that the distribution has a greater probability of being maintained or even increased.

Investor Alert: Avoid MLPs with Distribution-Coverage Ratios Not Exceeding 1

An important financial ratio to consider is the distribution-coverage ratio:

Distribution-Coverage Ratio=Distributable Cash Flow per Unit
Cash Flow Actually Distributed

The more that the distribution-coverage ratio exceeds 1, the safer the MLP investment. Although this is not a guarantee that the MLP will remain safe, since the underlying business can change, it at least indicates that the distribution is sustainable based on current earnings. A distribution-coverage ratio less than 1 indicates that the MLP is using its own capital, or worse yet, using debt to pay for some or all its distributions, a situation that will eventually lead to a reduced distribution with the concomitant sharp drop in unit price.

MLP Taxation and Distributions

The Tax Reform Act of 1986 provided the legal foundation for master limited partnerships to attract capital for the development of energy infrastructure. However, partnerships are mostly governed by state laws, so most MLPs are organized under the state of Delaware, since its laws are most favorable to businesses of all types.

Most of the income generated by MLPs are used to pay quarterly distributions, which is specified in the limited partnership contract. The requirement that an MLP distribute most of its cash comes from the partnership agreement, not from tax code requirements, such as those that apply to REITs or mutual funds. The partnership agreement has such provisions because most investors buy MLPs for their income. Indeed, the price of MLP units will vary with distribution amounts, so general partners try to keep the distribution amounts constant or increasing. However, the general partner will retain some cash to operate the business, to pay debts, and to maintain some reserve to maintain the quarterly cash distribution amount.

Because MLPs are partnerships, partnership tax rules apply. Initially, the cost basis that an investor has in an MLP unit is equal to the amount invested minus acquisition expenses, just like for stocks and bonds. MLP unitholders pay taxes on their allocated portion of net income earned by the MLP regardless of whether the income is distributed. The allocated income increases the tax basis of the MLP units; distributions decrease the tax basis, so tax liability is only incurred when the units are sold, as long as the tax basis is positive. When the basis is reduced to 0, then all succeeding distributions will be taxed at the capital gains rate. If held for longer than 1 year, then the gain will be taxed at the favorable long-term capital gains rate.

Because the tax basis for MLP units changes every year, you will have to keep track of your adjusted basis to determine any capital gain or loss when the units are sold.

Usually, distributions exceed income because most MLPs have large deductions, such as depreciation or depletion, which lowers taxable income but not cash flow. Because cash flow is the source of distributions, distributions are usually much larger than the taxable income allocated to the unitholders. This is why many MLPs advertise that only about 20% of their distribution is taxable. It is this tax treatment of the distributions that primarily differentiates distributions from dividends, which are taxed as they are received.

Like most limited partnerships, MLPs generally use leverage to increase returns. Losses incurred because of the debt can only be passed through to limited partners if they are at risk for the repayment of the loan, i.e. the loan is recourse. Losses associated with nonrecourse debt cannot be passed through to limited partners. An exception, known as qualified nonrecourse financing, exists for MLPs owning real property purchased with acquisition debt and secured by the real property that is subject to the at-risk rules. Unitholders can treat their apportioned amount of such debt as being at risk, even though they are not personally liable, thus lowering their taxable income.

The MLP manages the recordkeeping for taxes. The MLP reports the taxable distribution to the investor on Schedule K-1, showing the investor's share of income and loss experienced by the MLP during the year. Other tax items that can be passed through by MLPs are net income, tax-exempt bond interest, and gains on §1231 property.

Because MLPs are publicly traded partnerships, losses are treated as passive losses. For other investments, passive losses can be deducted from passive gains from other investments. However, there is a special tax rule for publicly traded partnerships that states that passive losses can only be deducted against gains by the same partnership, so any losses will have to be carried forward until the partnership earns a profit or until the investor disposes of the entire interest in the partnership.

Depreciation

When the MLP units are sold, then any gain will be taxable. Some part of the gain will be due to depreciation recapture that is subject to ordinary income taxes. Some of the gain may be attributed to appreciated inventory or unrealized receivables that is also taxed as ordinary income. If the units were held longer than 1 year, then any remaining gain will be taxed at the favorable long-term capital gains rate; otherwise, the entire amount will be subject to ordinary income tax. The allocation of the gains will be reported on Form K-1. The reason why different portions of the gain are taxed differently is that depreciation or depletion is deducted against ordinary income, so when it is recaptured, ordinary income tax rates apply to the recaptured portion. Likewise, business income is subject to ordinary income taxes, so any gain attributed to appreciated inventory or unrealized receivables is taxed as ordinary income. Thus, a unitholder may have a taxable gain even if the MLP units were sold at the same price at which they were bought. Only the amount remaining after subtracting the cost basis and the recaptured depreciation from the sales proceeds of the MLP units will receive the favorable long-term capital gains treatment if the units were held longer than 1 year.

If the MLP owner dies, the MLP units are stepped up to their current value and any depreciation recapture is nullified, because the beneficiaries receive the MLP units with a basis equal to their value when the decedent died.

K-1 Package

Between late February and early April, most MLP unitholders will receive a K-1 package, which will consist of Schedule K-1, an ownership schedule, a sale schedule, and a state schedule. K-1's can also be downloaded from the company's website.

Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. consists of 3 parts:

  1. Part I provides information about the partnership, including that it is a publicly traded partnership.
  2. Part II provides information about the limited partner.
  3. Part III reports the share of income, deductions, credits, or other items for the tax year. These are the items that flow through from the MLP to the taxpayer.

The ownership schedule shows the purchases and sales made by the taxpayer, including the dates and the unit quantities.

The sales schedule shows any sales that the taxpayer has made during the tax year. This part will also list the portion of the gains that are subject to ordinary income taxes, primarily depreciation recapture. The remaining part is capital gain.

The state schedule shows which states in which the MLP operates. A taxpayer with a significant investment in the MLP may be required to file state tax returns for each of the listed states. The state schedule shows the portion of income allocated to each state.

Do Not Hold MLPs in Tax-Exempt Accounts

MLPs should be held in taxable accounts because of their tax advantages. Moreover, because MLPs are active businesses, they should not be held in tax-deferred or tax-exempt accounts, such as traditional and Roth IRAs, because the total of such income from all sources that exceeds $1000 will be subject to the unrelated business income tax (UBIT) that is assessed on tax-exempt entities when they conduct a business unrelated to its exempt purpose (IRC §§511-514). IRAs are considered separate entities from the taxpayer, so the custodian of the IRA would have to pay the UBIT by filing Form 990-T. Additionally, because IRAs are trust accounts, they must pay the marginal tax rates of trusts: the tax brackets are the same as for individuals, but at much lower income levels. For instance, the top 39.6% marginal tax rate applies to any trust income that exceeds $11,950 for tax year 2013, adjusted annually for inflation. The purpose for the UBIT is to level the playing field between taxable businesses and tax-exempt entities conducting businesses that compete with each other.