A master limited partnership (MLP) is a publicly traded limited partnership. Shares are called “units” and trade on an exchange. Most MLPs are in the energy industry.

How They Work

MLPs and corporations are not the same. A corporation is a distinct entity, from both a legal and tax standpoint. Though shareholders contribute capital, they do not incur any liability for the corporation’s financial obligations.

An MLP is an aggregate of its partners. As a result, the limited partners are liable for the partnership’s obligations and could potentially be forced to repay any capital distributions received. (While this is rare, the rule can impact investors even after they have sold their units, depending on liability’s creation date.)

To qualify for MLP status, a company must receive at least 90% of its income from interest, dividends, real estate rents, the sale or disposition of real property, commodities or commodity futures, and mineral or natural resources activities.

Taxes

MLPs also differ from corporations in terms of their tax structure. Corporations, as a distinct tax entity, pay taxes on earnings. Conversely, MLPs do not pay taxes on income. The earnings and the tax liability are passed along to unit holders. An investor’s share of the partnership’s net income is taxed at his or her individual tax rate.

Cash Flow Distributions

Even though the MLP passes pretax income to investors, actual cash distributions are made to unit holders based on a “distributable cash flow.”

The cash flow distributions are not taxed when they are received by investors but are considered reductions in the investment’s cost basis (the per unit price paid for the investment). The cost basis is reduced by the net of cash distributions and amount paid in taxable income. For example, if each unit of the MLP pays $2 in income tax and earns $5 in distributable cash flow, then the cost basis of the investment is lowered by $3. If the original cost was $17 per unit, then the cost basis is lowered to $14.

The lowering of the cost basis creates a tax liability that is deferred until units of the MLP are sold. If the investment’s cost basis falls to zero, cash distributions become immediately taxable. Continuing the above example, if the investor sells a unit at $20, the unit holder pays capital gains tax on the $6 difference between the cost basis and the selling price.

Cash distributions are not guaranteed or required, but investors are taxed on their share of income whether or not a cash distribution is made.

The Pros

Tax Advantages

MLP unit holders can avoid the double taxation of corporations paying dividends. Unit holders can also defer taxes on cash distributions.

Historically Higher Yields

MLPs can typically make larger cash disbursements, leading to higher yields as compared to stocks and bonds.

Low Correlation With the Market

Historically, MLPs have low correlations with both stocks and bonds. Many investors use MLPs to diversify their holdings.

The Cons

Complicated Tax Rules

Owning units of an MLP can be complicated come tax time. Investors need to track and pay their portion of taxes on income. Investors also need to track the cost basis of the investment based on cash disbursements and taxes paid.

Potential Liability

Due to the structure of the MLP, all partners are liable for loans and other obligations. Cash disbursements can also be clawed back if needed to pay outstanding obligations.