An Intro to MLPs, Part one

A master limited partnership (MLP) is a pass through structure much like a REIT. The limited partnerships are traded on exchanges as shares. Because they are structured as a partnership instead of a normal corporation they do not pay corporate level taxes. Rather, they are deferred to the limited partners who are taxed at their individual rate of their share of the partnership’s income. This tax structure avoids the double taxation of dividends resulting in a much lower required cost of capital.

The distribution’s made to limited partners come from the firms distributable cash flow instead of the partnership’s income. The distributions are not taxed as they are incurred but are reduction in the cost basis of the investment creating a tax liability until the shares of the MLP are sold. This means that only a minimal amount of the distribution is considered taxable and the rest is a return of capital. Because of these tax exempt distributions an MLP should be owned in taxable account and distributions to tax exempt account and tax exempt institutions may be considered an UBIT. As a result, MLPs are generally only held in retail accounts as individual stocks or in a mutual fund.

For a company to qualify as an MLP, 90% of income must be received from qualifying sources such as natural resources, activities associated with natural resources (exploration, production, transportation, etc.), interest, income derived from real estate and the sale of assets. This results in companies predominantly from the energy sector being MLPs. 107 of 140 of publically traded MLPs are in the energy sector. The majority of these companies are either upstream or midstream companies. MLPs allow investors to expose themselves to natural resources without investing directly into the resource while maintaining a low beta.

Part 2 will consist of information pertaining to distributions, the history and the future of MLPs.