Master Limited Partnerships (MLPs) are a hybrid investment vehicle that offers the tax benefits of partnerships combined with the liquidity and tradability of publicly listed securities. Established in the 1980s with the Revenue Act of 1987, MLPs were designed to attract investment into capital-intensive industries, especially energy infrastructure, by avoiding double taxation typically imposed on corporations.
How MLPs Work
An MLP has two types of partners: the General Partner (GP) who manages operations and bears unlimited liability, and the Limited Partners (LPs), who are investors owning units traded on public exchanges. Unlike corporations, MLPs do not pay corporate income tax. Instead, they pass earnings directly to unitholders, who report this income on their personal tax returns via a Schedule K-1, detailing their share of the MLP’s income, deductions, and credits. This pass-through structure eliminates double taxation but introduces complexities in tax reporting.
Typical Industries and Income Qualification
MLPs predominantly operate in midstream energy sectors—pipelines, storage, and processing facilities related to oil and natural gas—due to IRS rules requiring at least 90% of their income to come from qualifying natural resource-related activities. This focus provides relatively stable, fee-based revenue streams supporting consistent cash distributions to investors.
Tax Considerations
Distributions from MLPs are often classified as a return of capital, reducing an investor’s cost basis rather than creating immediate taxable income. This defers taxes until the MLP units are sold. However, owning MLPs in tax-advantaged accounts like IRAs can trigger Unrelated Business Taxable Income (UBTI) complications, potentially resulting in unexpected tax filings and liabilities if UBTI exceeds $1,000.
Investors receive a Schedule K-1 (rather than a 1099 form), which may arrive later in tax season and includes various income types that must be reported appropriately, often necessitating specialized tax preparation. At FinHelp, we’ve detailed the challenges and remedies for handling K-1 forms in our articles on Relief for Incorrect K-1 Income Reporting and CP275 Notice for Missing Partnership Schedule K-1.
Who Should Consider Investing in MLPs?
MLPs are appealing to income-focused investors seeking steady, tax-deferred cash distributions, particularly retirees or those supplementing income. They also suit investors bullish on the long-term significance of energy infrastructure. However, potential investors must carefully assess MLP operating risks, tax complexities, and interest rate sensitivity before investing.
Investment Strategies
Successful MLP investing requires diligent research on underlying assets, management quality, and distribution sustainability. Diversification across various MLPs can manage sector-specific risks. Understanding the tax nuances and preparing for delayed K-1 tax forms ensures smoother tax season compliance.
Comparison with Other Investment Types
Compared to C-corporations and REITs, MLPs offer a unique tax pass-through advantage but require more complex tax reporting. Unlike typical dividend payouts, MLP distributions mostly constitute a return of capital, impacting an investor’s cost basis and capital gains calculation.
Common Pitfalls
Investors should avoid treating MLPs like regular stocks, disregarding K-1 complexities, blindly chasing high yields, misplacing MLPs in IRAs without considering UBTI consequences, and overlooking the long-term tax impact of return of capital distributions.
For more detailed insights on tax forms and partnership implications, visit our resources on Schedule K-1 (Form 1041) and our guide to Tax-Advantaged Accounts.
Authoritative Sources
- Internal Revenue Service. “Partnerships.” https://www.irs.gov/businesses/partnerships
- Investopedia. “Master Limited Partnership (MLP).” https://www.investopedia.com/terms/m/mlp.asp
This comprehensive overview equips investors with a clear understanding of MLPs’ benefits and challenges, preparing them to make informed decisions in this specialized investment area.