Headline: Mastering the Limited Partnership
Date: November 11, 2020
There was a recent Yahoo Finance article, entitled, “COVID Pandemic has Upended MLP’s” https://www.yahoo.com/now/covid-pandemic-upended-mlps-190000693.html
This article made me think that I might benefit from learning more about this very interesting investment possibility.
What is a Master Limited Partnership?
A Master Limited Partnership (MLP) is a partnership (listed and traded similar to equities) that obtains 90% of its’ revenue from extraction, refinement or transportation of natural resources. MLPs are often organized to build pipelines and similar large structures to support the fossil fuel industries. As of late, their popularity has mushroomed: Per Barron’s, in 2000, there were just 18 MLPs with market cap of only $14B. A few years later, Barron’s ran the same survey, and located 113 of them with a market cap of $460B.
In this form of business, there are limited partners and one general partner. The limited partners make contributions when they purchase units of the partnership, and can expect to obtain regular cash flows. The general partner is also entitled to receive incentive distribution rights, which motivate them to run the partnership profitably. Since the MLP is required to make quarterly distributions, this investment can make sense for those who require current income.
Are there different varieties of MLP?
Yes, there are different varieties of MLP. There are “upstream MLPs” that focus upon the exploration, development and recovery of fossil fuels and other resources. There are “midstream MLPs” and these focus upon the gathering and transportation of the resources. This portion represents the majority of the MLPs in the marketplace today. They can sometimes be defamed with the sobriquet, “toll collectors”, but in this role, they can weather many changes in economic environments. Finally, there are “downstream MLPs’” that focus upon distribution of the resources to end users.
Why is this form of ownership attractive?
This form of ownership is very attractive because of its’ tax attributes. First, it is a sort of partnership, so, it avoids double taxation (as there is none at the entity level.) Second, the MLP will often distribute cash in excess of the taxable income (because it is based upon Distributable Cash Flow), and this excess of cash is a “return of capital” and is tax-deferred, lowering the cost basis of the investment. If the cost basis is minimized to zero, then the further distributions are considered to be capital gains, and are taxed at preferential rates. Upon sale of the MLP, the unitholder will derive both ordinary income and capital gain. Further, if this investment is used as an estate planning strategy, the heir will likely get a “stepped up basis” and will be able to sell it immediately sans any capital gains tax.
If one is concerned about diversification, there are EFTs that trade in MLP ownership.
What is unattractive?
Basically, paperwork can be more involved for this type of investment. The unitholder will receive a K-1 to record distributions, and taxes will often be due to several states. For these reasons, the unitholder will likely end up paying their tax preparer more to prepare their more complicated paperwork. It should also be noted that when an MLP incurs a loss, it is passed thru to the unitholder as a passive loss, only usable against passive income or when the interest is disposed of in a taxable transaction.
What is the future for MLPs?
We are unlikely to become materially less dependent on oil and other resources in the near future, so the MLP’s future might seem secure. But, many MLPs are converting to corporations. This is a result of the recent decrease in corporate tax, and the additional costs of the IDR payments.
References:
Master Limited Partnership – MLP Definition (investopedia.com)
What Is a Master Limited Partnership? | The Motley Fool
SEC.gov | Updated Investor Bulletin: Master Limited Partnerships – An Introduction
Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice. Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.