MLPs offer some investors the ultimate package: tax advantages plus liquidity.

Motley

Updated: Mar 31, 2019 at 4:16PM

Theres a world of investment options out there that extends far beyond stocks and bonds. One such example is the master limited partnership.

A master limited partnership, or MLP, is a limited partnership that is traded publicly on an exchange. An MLP combines the tax benefits of a limited partnership with the liquidity that publicly traded securities -- like stocks and bonds -- offer.

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How MLPs work

There are two types of partners in an MLP: general partners and limited partners. General partners oversee the daily operations of the MLP. All other investors in an MLP are limited partners, and their role is to provide capital to the MLP.

The limited partners, in turn, get to collect distributions from the MLPs cash flow. Limited partners do not get involved in an MLPs operations. Also, while limited partner units are publicly traded, general partner units usually are not.

General partners typically own a small general partnership stake of the MLP, though they can also own limited partner units to increase their ownership percentage. Those who invest in MLPs are referred to as unitholders because they buy units of the partnership. Investors are paid through quarterly required distributions as specified in their contracts.

Because MLPs are not required to pay corporate taxes, they have more cash available to distribute to investors. To receive these tax benefits, MLPs must generate at least 90% of their income from qualifying activities, such as those related to natural resources, commodities, or real estate.

Companies that take advantage of the MLP format are typically those that operate in steady, slow-growing industries. Because of this, cash distributions from MLPs tend to remain relatively steady over time. Furthermore, unlike corporations that issue stock, MLPs do not retain earnings for growth. Rather, they distribute them to investors as they become available.

Benefits of investing in MLPs

One major benefit of MLPs is that they tend to offer attractive yields, especially as compared to bonds. Furthermore, because MLPs typically emerge from stable, slow-growth industries, they tend to produce steady cash flows on a long-term basis.

There are also tax benefits to investing in MLPs. Limited partners in an MLP are only taxed when they receive distributions. Those cash distributions often exceed partnership income. When they do, its considered a return of capital to the limited partners, which means that applicable capital gains taxes are deferred until the units of the MLP are sold.

Drawbacks of investing in MLPs

One major drawback to MLPs is that the taxes around them can get complicated, including having to deal with a Schedule K-1. With an MLP, each unitholder is responsible for paying his or her share of the partnerships income taxes, which can pose a challenge from an accounting perspective. Additionally, unitholders may be responsible for paying taxes on partnership income, even if the units in question are held in a retirement account.

Owning an MLP in a retirement account can create whats known as unrelated business taxable income, or UBTI. If that figure exceeds a certain threshold, it becomes subject to taxes, thus negating a major benefit of having a retirement account in the first place.

Though MLPs are a solid investment opportunity for some people, theyre not for everyone. Those who prefer more straightforward investments may be better served buying stocks or bonds -- investments whose tax consequences arent nearly as complicated. 

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