Master Limited Partnership
A publicly traded business taxed as a partnership in the United States
Updated:
September 15, 2022A master limited partnership (MLP), similar to a publicly traded partnership (PTP), is a publicly traded business taxed as a partnership in the United States. It combines publicly traded securities' liquidity with a partnership's tax advantages.
MLPs must derive at least 90% of their income from sources that qualify, such as the production, processing, storage, and transportation of depletable natural resources and minerals, to benefit from the tax advantages of a pass-through.
Although the terms "MLP" and "PTP" are frequently used together, MLPs are a type of limited partnership that runs its business through subsidiaries and isn't typically listed on a stock exchange.
Although MLPs make up the majority of PTPs, a PTP can also be set up as a limited liability company that chooses to be taxed as a partnership.
MLPs were structured like private investments even though they were publicly traded like stocks and, as a result, were soon frequently employed to exploit several tax breaks.
After the IRS became aware of this, legislation was passed in 1986 and 1987 that severely limited the operations of MLPs.
However, MLPs are still widely used today and can still have a place in portfolios, particularly for investors focusing on particular sectors of the economy.
A private partnership arrangement's tax advantages are combined with a public company's liquidity and accessibility to investors in an MLP.
The master limited partnership's definition, operation, benefits, and disadvantages in more detail.
What is a partnership?
A partnership is a type of business where two or more persons jointly own the company and are responsible for managing it and for any profits or losses it makes.
Organizations may work together to expand their reach and increase the likelihood that each will succeed in reaching their goals. A partnership may solely be controlled by a contract, or it may issue and hold stock.
The business is not taxed separately as companies are based on their earnings or losses; rather, the income is paid to partners who subsequently deduct it from their tax returns.
Three different kinds of partnerships exist:
1. Limited Partnership
Each partner in a general partnership contributes equally to the work, liabilities, and earnings that are generated and distributed to the partners. Every partner actively participates in running the company.
Typically, general partners are in charge of major business choices as well as overseeing a company's day-to-day expenses and operations.
Additionally, they are fully liable for any debts incurred by the company. Limited partners frequently lack direct control over expenses or business operations and are not held fully accountable for their participation in a company.
2. Limited Liability Company
Depending on their contributions, limited partnerships enable outside investors to invest in a company while maintaining only limited liability and engagement. This type of collaboration is more complex and offers greater ownership and decision-making flexibility.
3. Joint enterprise
Joint ventures are frequently used to form short-term alliances or projects that involve numerous participants. If the business succeeds, it can carry on as a general partnership. If not, it may be closed.
Pros and Cons of Partnership
The decision to establish a business as a partnership has several benefits, which include:
Partners can combine their resources to finance the start-up of the business because it is quite simple to set up and maintain over time.
Partners can split the workload and benefits of the company's success.
Being able to offer important employees the chance to one day become a partner in the business can be a major incentive that pushes them to stay long-term.
Of course, there are drawbacks to entering a partnership where there are benefits:
Where there are multiple owners, there will inevitably be disagreements that could damage the company.
Even though partners split any earnings, the firm makes, disputes may arise if the distribution does not reflect each partner's commitment to the operation.
Partnerships have both joint and individual liability, in contrast to corporations, which help to shield owners from liability. In other words, each partner is responsible for both their conduct and that of their other partners when acting on behalf of the business.
Partnership Features
The following fundamental characteristics will always characterize a typical partnership form of business.
1. Consensus
It is evident from the definition of a partnership that there must be an agreement between partners before they may collaborate and split earnings. Such an agreement may be made verbally or in writing by the partners.
This refers to such an arrangement as a partnership deed if it is in writing.
The partners must be clear about their standing as partners of their firm in the written or oral agreement. This contains information about their roles as partners, the companies run by the firm, their profit-to-loss ratio, etc.
2. Business
A crucial aspect of partnerships is the presence of a business. If the organization engages in philanthropic endeavors, there cannot be a formal partnership under the Partnership Act.
Any trade, profession, or occupation is considered to be a business, according to Section 2.
The company must operate to make money. This is crucial.
3. Compensation
If partners do not split the company's profits, a partnership does not exist. An individual working for a partnership business but not participating in its earnings is an employee, not a partner.
It is important to understand that the law only mandates the partners to split earnings. As a result, all partners don't need to share in losses, according to BK Law Group.
4. The principal-agency partnership
One partner may act on behalf of all other partners, or the entire partnership may conduct business collectively. We frequently refer to such an odd arrangement of partners as the "principle of agency."
According to this theory, each partner acts as the other's agent. Any decisions made by one partner in the normal course of business will also bind the other partners. Each partner is responsible for the firm's actions individually and jointly.
What is a Master Limited Partnership?
In an MLP organization, general partners and limited partners make up the majority of the partners.
In exchange for a tiny ownership position, general partners (GPs) run the MLP's daily operations while maintaining board and management authority. The term "limited partners" or "unitholders" refers to regular outside investors.
Quarterly cash distributions to limited partners are customarily made by MLPs, and each partner is given a K-1 form to report them (rather than the 1099 form used for corporate dividends).
These cash payments constitute a proportionate amount of the partnership's distributable cash flow, which also includes depreciation, depletion allowances, tax credits, and other tax deductions in addition to income from the MLP's activities.
Each partner's share of income gain, loss, deductions, and tax credits for that tax year will be detailed on the K-1. They don't participate in management decisions but contribute money to the MLP's purchases.
MLPs are renowned for their consistent revenue streams and substantial profits. The yields of several individual MLPs are greater than 10%.
How are they so tall? Due to the requirement that MLPs contribute 90% of their income to shareholders. They cannot invest as much money as they like in the business or spend as much on expansion as conventional corporations may.
These returns take the shape of gains from selling the investment properties or income produced by them.
How is MLPs Taxed?
However, there's still more. MLPs can have some tax benefits that increase returns.
An MLP has a "pass-through entity" structure. Therefore it doesn't incur any tax liabilities on its own. Therefore, potentially, investors receive higher distributions of money.
If an MLP is treated as a corporation for federal income tax purposes, its revenue is taxed once at the level of the business entity and once more at the level of each partner when dividends are paid out.
Individual MLP investors are consequently prohibited from claiming some tax benefits on their tax returns, including depreciation, deductions, and tax credits.
Losses are carried over by the partnership as net operating losses rather than being passed through to the partners. Investors in MLPs should be aware of the tax repercussions of their decision.
The classification of the quarterly payouts is another consideration. It serves as income at times. However, distributions can also be thought of as a return of capital, which is not taxed when received by the unitholder.
The Advantages of Purchasing MLPs
Investing in master limited partnerships has benefits and drawbacks, just like any other investment. Among the benefits:
1. Tax advantages
As a pass-through corporation, the MLP is exempt from paying income taxes, which can increase investment returns. Returns may be subject to capital gains tax in addition to income tax.
Your cash distributions are treated as a return of capital and, therefore, can lower your cost basis when you sell your units. However, they cannot reduce your cost basis below zero.
Once your cost basis for the MLP reaches zero, any future distributions will be taxed as capital gains for the year in which they are received.
2. High yields
MLPs provide returns that are above average. For instance, the Alerian MLP ETF (AMLP) yields nearly 25%, according to a list published by Sure Dividend, an investment advisor specializing in MLPs, as opposed to the S&P 500's around 2% average dividend return.
3. Reliable returns
MLPs are investments because they operate in sectors with a history of solid returns.
MLPs could give investors an appealing total return because of distributions that normally yield 6-8% (and are growing by 5- 10% yearly) and the possibility of capital gains.
4. Transparency/liquidity
Unlike traditional private, limited partnerships, MLPs allow for the easy sale of their units on a public exchange and offer greater price transparency.
The Problems with MLPs
Like other types of investing. MLP has disadvantages as well to be taken into consideration before investing in such portfolios. It may include:
1. Unexpected tax consequences
If one holds their shares in a tax-deferred account, such as an IRA, the distributions may be classified as taxable income, and it would then be required to pay annual taxes on unrelated company income (UBI).
2. Lack of diversification
These funds are not diversified investments because they are restricted to certain industries—the majority of contemporary MLPs concentrate on oil and gas firms. They are a very specific industry play, to put it another way.
3. Low growth potential
Since MLPs disperse the majority of their cash to investors, there isn't much money left over for growth or reinvestment. MLPs run the danger of needing to incur more debt to pay for operations or cover expenses if they are not carefully managed.
4. Complicated tax filings
MLPs use a particular tax form called a K-1 to declare their dividends. These are infamous for being provided to investors late and might be challenging to understand. All of this makes filing your tax return more difficult.
MLP and Retirements Account
An institution or account that is exempt from taxation must pay tax on income that is not derived from the activity for which it is exempt, according to the Internal Revenue Service. The "unrelated business income tax" is the name of this tax law clause (UBIT).
Income from an MLP is deemed to have been earned directly by each partner when it is passed through to the limited partners without being taxed at the partnership level.
The tax code recognizes a retirement account as the unitholder when it contains MLP units. As a result, the UBIT on the MLP's part of the retirement account's taxable business income applies (minus any deductions or depreciation reported on the K-1).
The first $1,000 of the account's net income from the MLP may be deducted. However, the remaining $1,000 is subject to the UBIT.
Businesses that benefit from the MLP arrangement are often ones that work in stable, slowly expanding sectors. As a result, cash distributions from MLPs usually continue to be quite consistent over time.
Furthermore, MLPs do not hold on to earnings for expansion like firms that issue shares do. Instead, they distribute them as they become accessible to investors.
Summary
Master limited partnerships have some tax advantages due to their special structure, which enables them to report exceptionally large yields. Additionally, they are more open and liquid than conventional partnerships.
But not everyone should use this novel investing structure. Researching the MLP itself should be your first step if you are thinking of taking this path.
To be sure that the MLP has a stable stream of cash flow, you should first consider how it raises money. However, you should also consider how much cash the MLP is holding in contrast to its dividends.
The IRS has the authority to revoke the MLP's tax-exempt status if it fails to distribute 90% of its profits as required by law. Following that, the partnership and its unitholders may incur significant tax liabilities.
Companies that are involved in the exploration, production, processing, or transportation of natural resources are generally considered to be master-limited partnerships. They might concentrate on real estate.
Oil and gas pipelines could be owned and run by an MLP. It might also concentrate on finding and producing crude oil. MLPs that harvest and refine natural gas may also be found.
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