Complexities of Master Limited Partnerships (MLPs)

Defining Master Limited Partnerships (MLPs)

Master Limited Partnerships (MLPs) blend the fiscal benefits of private partnerships and the liquidity perks of publicly-traded companies into a unique business model. As publicly-traded entities, they offer cash flow consistency and are bound by a partnership agreement to distribute specified amounts to their investors. This framework also helps mitigate the cost of capital for businesses demanding substantial capital, like those in the energy sector.

The MLP journey started in 1981. But in 1987, the U.S. Congress restricted their application mainly to real estate and natural resources sectors to prevent substantial corporate tax revenue loss, given that MLPs are exempt from federal income taxes.

Grasping the Master Limited Partnership Structure

A hybrid of a partnership and corporation, an MLP operates as a collective of its partners rather than an independent entity, unlike a corporation. This structure doesn't have employees; instead, the operational services are provided by general partners who typically hold around 2% of the venture's stake with options to increase their ownership.

Instead of shares, MLPs issue units, frequently traded on national stock exchanges, hence offering liquidity. As these publicly traded units are not stock shares, investors in MLPs are generally known as unitholders rather than shareholders.

There are two partner types in MLPs:

• The limited partners or silent partners are investors who purchase units in the MLP, providing capital for operations. They receive periodic distributions, typically every quarter.
• The general partners manage daily operations and are compensated based on the business's performance.

What Tax Implications Do MLPs Have?

In the realm of taxation, MLPs are considered limited partnerships, a standing that lends a significant tax advantage to investors. It operates under a pass-through, or flow-through, tax framework, meaning all profits and losses are directly passed on to the limited partners. Unlike most businesses incorporated, an MLP does not pay taxes on its revenues. Instead, the limited partners pay income taxes on their individual share of the MLP's earnings.

Further, the benefits of deductions, such as depreciation and depletion, are also passed to the limited partners. These deductions can be effectively utilized by limited partners to lower their taxable income.

One of the crucial stipulations to maintain the pass-through status is that at least 90% of the MLP's income has to be qualifying income. This includes income realized from the exploration, production, or transportation of natural resources or real estate.

This means, to be classified as a master limited partnership, the company has to generate 90% of its revenues from natural resources or real estate activities. This qualifying income definition limits the sectors where MLPs can operate.

The Impact of Deferred Taxes and the Capital Gains Tax Rate

Distributions from MLPs, which are done quarterly, are similar to stock dividends. However, a part of the distribution is considered as a return of capital (ROC) instead of dividend income. As such, the unitholder does not pay income tax on the distribution. The distribution decreases the cost basis of units.

Tax deferment on these distributions continues until unitholders sell their interests in the MLP. At this point, the difference between the cost basis and sale price is taxed at a blend of the ordinary income tax rate (on the return of capital distribution) and the capital gains tax rate (on the appreciation of the units since purchase). This tax treatment offers another substantial tax advantage.

Weighing the Pros and Cons of MLPs

Just like any investment, MLPs come with their own set of advantages and disadvantages. They may not be suitable for all investors. Before making an investment, an investor must balance the drawbacks against the potential benefits of owning units of MLPs.

Advantages

• MLPs are recognized for providing consistent, albeit slow, investment returns. This is because MLPs often operate in slow-growth industries, such as pipeline construction, making them relatively low risk. They generate stable income often based on long-term service contracts, resulting in steady cash flows and regular cash distributions.
• Cash distributions from MLPs generally grow at a pace slightly faster than inflation. For limited partners, 80% to 90% of the distributions are often tax-deferred. This allows MLPs to offer attractive income yields—often considerably higher than the average dividend yield of equities. Coupled with the flow-through entity status (and the absence of double taxation), there is more capital available for future projects, helping the MLP stay competitive in its industry.
• Additionally, the total cash distributions for the limited partner could exceed the portion taxed at the capital gains rate once units are sold.
• Liability for an MLP's debts and obligations for limited partners is limited to their capital contribution.
• Up until the 2017 tax cuts act benefit expires in 2025, investors can deduct 20% of their distributions from their taxable income, effectively reducing the tax they would otherwise pay.
• MLPs can also have significant benefits for estate planning. When unitholders gift or transfer the MLP units to beneficiaries, both unitholders and beneficiaries evade paying taxes during the transfer. The cost basis gets readjusted based on the market price at the time of the transfer if the transfer occurs due to death. There is no step-up in basis if the MLP's units are gifted. Should the MLP units be sold in the future, beneficiaries will pay capital gains taxes only on the appreciation of the units' value from the time of inheritance to the time of sale.

Disadvantages

• The tax filing requirements for MLPs are complex and often require the aid of a tax professional. This is due to MLPs sending out K-1 forms instead of 1099 forms to their investors. K-1 forms are far more complicated than 1099 forms, and they may increase the cost of tax preparation.
• MLPs also issue a Schedule K-1 for each state in which they operate, potentially subjecting the unitholder to file state tax returns in multiple states.
• MLP net losses cannot offset other types of income on a unitholder's tax return, unlike other investment losses. However, net losses may be carried forward to the next year's tax returns, offsetting income in future years.
• Limited upside potential: Given the focus on stable income generation over time, growth opportunities are limited for most MLPs, so unitholders should not expect significant capital appreciation.
• MLPs are not ideal for retirement accounts. Unrelated Business Taxable Income (UBTI) generated by an MLP could be taxable in an Individual Retirement Account (IRA), even though income in an IRA is generally tax-free until withdrawal. If an IRA earns more than $1,000 of UBTI in a year, the amount over $1,000 is taxable. However, this rule does not apply to regular taxable accounts.

Examples of Master Limited Partnerships

The energy sector, particularly oil and gas, houses most MLPs. They often provide resources and manage services for other energy-based businesses. Some corporations own significant interests in their MLPs, and these corporations may establish separate companies that own the general partner and a substantial limited partner interest in the MLP.

Some of the prominent examples of MLPs include Enterprise Products Partners L.P. (NYSE: EPD), Kinder Morgan Energy Partners L.P. (NYSE: KMP), and Plains All American Pipeline L.P. (NYSE: PAA).

To conclude, MLPs offer a unique blend of advantages that can potentially increase the diversification of an investor's portfolio and provide a steady stream of income. However, the complexities surrounding taxation and the potential implications for estate planning necessitate careful consideration and, often, the advice of a financial advisor.

MLPs in the Future

Master limited partnerships (MLPs) might see increased attention as potential investment opportunities in the future. MLPs offer an attractive investment due to their steady cash flows and high yields, particularly in a low interest rate environment.

However, a few considerations should be kept in mind while predicting the future of MLPs.

1. Energy transition: With the global push towards clean energy and the reduction in the usage of fossil fuels, traditional MLPs that are heavily concentrated in the oil and gas sectors might face challenges. However, there is potential for MLPs in the renewable energy sector, provided the current regulations around qualifying income change.

2. Interest rate environment: As previously mentioned, MLPs tend to flourish in a low-interest-rate environment due to their high yield distributions. Any changes in interest rates will have an effect on the attractiveness of MLPs to investors.

3. Regulatory changes: Tax policies and regulatory rules are a major factor affecting MLPs. Any changes in these policies could have significant impacts on MLPs and their distributions.

4. Market volatility: MLPs, like any other investment, can be influenced by general market conditions and volatility. Although they are generally considered to be less volatile due to their stable cash flows, they are not completely immune to market shifts.

Considering all these factors, it is wise for potential investors to continually monitor the evolving landscape of MLPs and adjust their portfolios accordingly. Regular consultation with a financial advisor can provide insights into the risks and rewards associated with MLPs and guide decisions on whether to include them in an investment portfolio.

Lastly, as with any form of investment, diversification is key. Even within MLPs, diversification can be achieved by investing in MLPs across various sectors and sub-sectors, thus spreading risk.

In conclusion, MLPs serve as a valuable component of an investor's portfolio due to their high yield and steady cash flows. However, the complexities surrounding taxation, potential regulatory changes, and the ongoing energy transition mean that potential investors must undertake careful consideration and seek professional advice when investing in MLPs.