How to Invest in an MLP: Tax Benefits and Liquidity?

With the recent surge in oil prices and the increasing interest in alternative, renewable energy, you may consider investing money in energy-based companies. Master limited partnerships (MLPs) offer a tax-friendly way to invest in the oil and gas industry or renewable energy and receive regular distributions from revenue. Learn more about MLPs and whether they would be a good fit for your portfolio.

What is an MLP?

A master limited partnership (MLP) is a business enterprise that operates as both a publicly-traded entity as well as a limited partnership, which is a type of business entity. It provides investors with the liquidity of publicly-traded assets and the tax advantages of a limited partnership.

MLP units could be easily bought and sold on the stock market. At the same time, MLPs don’t pay federal income tax so the profits and losses are passed on to investors.

The first MLP was introduced in 1981 by the Apache Oil Company, and the tax-friendly enterprise gained popularity gradually over the years. Many of the first MLPs formed were with other oil and natural gas companies, then real estate companies followed, and then a number of different industries, including hospitality and cable television. Even the Boston Celtics NBA team formed its own MLP in 1986.

The attractiveness of this asset class is that it provides a sort of tax loophole for businesses. Corporations are typically subject to double taxation on their profits. The company must pay corporate tax, and its shareholders are also taxed on the income they receive from their holdings. As a limited partnership, the MLP isn’t subject to corporate taxes, and the tax burden is instead “passed through” to its investors.

Fearing the federal government was losing too much corporate tax revenue, Congress clamped down on MLPs with the Tax Reform Act of 1986. The Act limited the use of MLPs to only those businesses with at least 90% of the income generated from natural resources, commodities, or real estate. Today, the majority of MLPs are in the energy sector, primarily in the oil and gas industry. More specifically, many are involved in energy infrastructure, such as building oil and gas pipelines.

How do MLPs work?

There are two types of investors in MLPs: general partners and limited partners.

General partners are those investors who manage the day-to-day operations of the MLP. They have a stake of ownership in the MLP that usually amounts to at least 2% and can be increased if they choose.

Limited partners are all the outside investors who hold an interest in the MLP. Their investment in the MLP helps keep the operation running.

Whereas public company stock is sold in shares, MLPs are sold in units. So limited partners are referred to as unitholders, not shareholders. But they could sell their units on the stock exchanges much like shares are sold.

Limited partners typically receive quarterly distributions from the MLP. The MLP doesn’t typically pay taxes on those distributions, and the tax burden is passed through to the unitholders or limited partners.

This benefits limited partners because their MLP distribution payments are larger than they would be if taxes were taken out. Unitholders also usually don’t have to pay income taxes on distributions from an MLP until they sell their units. Limited partners also receive allowances for deductions and depreciation.

Limited partners receive an annual Schedule K-1 statement from the MLP which outlines the unitholder’s share of the MLP’s income, deductions, credits, gains, and losses. As a limited partner, you would include this information on your annual tax return. The MLP also files a copy of the K-1 form with the IRS.

How distributions are taxed

Cash distribution payments to limited partners can be classified in two ways: as income or as a return of capital. If they are classified as income, then the unitholder is subject to federal, state, and local income tax.

On the other hand, if the distribution payment is classified as a return of capital, it is only subject to taxation when the limited partner sells the units. Any profit on the unit sales would be subject to capital gains tax. This could be advantageous for the investor because the long-term capital gains tax rate is typically lower than the income tax rate.

Pros of MLPs

There could be several advantages to investing in MLPs. Some of the advantages include:

Significant tax benefits

An MLP’s pass-through tax structure means they aren’t typically subject to corporate tax. That equates to larger distributions to investors. Investors also usually don’t pay taxes on the payouts they receive until they sell the MLP unit, and they may also save on taxes by claiming the distributions as capital gains rather than income.

Stable and dependable returns

The business sectors that can operate MLPs (energy, commodities, and real estate) are typically stable industries with a history of slow growth and steady returns.

Higher yields

The yields on MLPs are usually considerably higher than on standard stocks and bonds. For example, the dividend yield for the Alerian MLP ETF (AMLP) has been around 8% or 9% for most of the past five years, while the average dividend yield of the S&P; 500 is about 2%.

Transparency

Unlike traditional limited partnerships, the price of MLP units is transparent because they are sold on a public exchange.

Cons of MLPs

MLPs also have certain risks that you should consider before investing. The cons of investing in MLPs include:

Slow return on investments

Investing in an MLP isn’t going to make you rich overnight. MLPs focus on industries that typically have slow growth, such as oil exploration and pipeline construction. Also, since 90% of an MLP’s revenue must be distributed to investors, that leaves less cash flow to grow the business, and the MLP may have to take on additional debt to pay the bills.

Complicated tax liability

Since the MLP is a pass-through entity, the tax burden falls solely on the investor. This could complicate things when it's time to file your annual tax return.

The K-1 forms individual investors need to report their distributions could make filing your annual tax return a bigger chore and usually requires the guidance of a tax advisor. In other words, you may not want to do your own taxes if you own an MLP. The forms also have a history of being mailed out late, which could cause difficulties in your tax filing. Although the IRS has a March 15 due date for K-1 forms, that isn’t necessarily the date they will be sent to investors, which shortens the time you’d have to prepare your taxes before the April 15 tax deadline.

Inability to write off net losses

If the MLP you’ve invested in has a net loss for the year, you typically can’t write off the loss on your tax return like you would with other investments. You only deduct the loss from your income after you sell your units.

Volatility

MLPs may be subject to volatility based on several factors such as interest rates, legislation and regulations affecting the subject industry, and the price of commodities.

Who should invest in an MLP?

Investing in MLPs isn’t for everyone. Although they do come with some tax benefits, you may end up paying your accountant more to handle the complex paperwork involved with MLP investments.

If you have a great accountant or are an accountant yourself who can handle complicated tax issues, then investing in an MLP may be a way for you to earn above-average returns.

Because of the tax complexities of MLPs, many investors work with a wealth manager to purchase units. So if you are an individual investor looking for somewhere to put your money, MLPs may not be the best choice.

You also don’t want to include an MLP in your IRA retirement account because then the distributions will be considered “unrelated business taxable income” (UBTI), and you will end up having to pay income taxes on any distributions over $1,000. That would negate the tax benefits of an MLP. MLPs are prohibited in pensions, 401(k)s, and other tax-exempt investment funds for the same reason.

How to invest in an MLP

If you decide to move forward with investing in an MLP, it’s a good idea to enlist the help of the best online brokerage firm you can find to help you navigate through the options available.

Other steps to take when investing in an MLP include:

Select which industry focus you want the MLP involved in

What industry do you want the MLP to be involved with? The majority of MLPs are in the energy sector, but that sector is divided into several different subcategories.

Within the energy sector, there are MLPs involved in:

• The oil and gas industry, which is further broken down into the following three activities:
  • Upstream — crude oil and gas exploration and production
  • Midstream — transportation, storage, and exportation
  • Downstream — refining and distribution
• Propane
• Coal
• Natural resources/renewable energy

As you look at energy sector MLPs, consider how dependent on commodity prices, such as the price of oil, the MLP is. An MLP more dependent on commodity prices could be more volatile. There are also MLPs involved with finance and commercial real estate.

Look up the MLP paperwork filed with the SEC

Once you’ve found an MLP you’re interested in investing in, find out more about the MLP’s business strategy, forecasted distributions, and potential risks through the paperwork it’s required to file with the U.S. Securities and Exchange Commission (SEC).

The SEC’s Office of Investor Education and Advocacy recommends that investors look up an MLP’s prospectus (Form 424), annual report (Form 10-K), and quarterly reports (Form 10-Q) before buying any units. Those financial statements are available on the SEC’s EDGAR system.

Ask questions

According to the Institute of Business & Finance, there are specific questions you or your advisor should ask about an MLP before investing in it. Some questions to ask include:

• What is the distribution sharing arrangement between the MLP’s general partners and limited partners?
• What portion of the distribution payments are tax-deferred?
• Are annual multistate tax filings and payments required?
• What happens to your MLP investment if you die?
• What are the tax consequences if you give MLP unit(s) as a gift to a person or entity?

FAQs

Bottom line

Investing in the oil and gas industry or putting your money behind renewable energy companies may be a wise choice and offer diversification for your investment portfolio. MLPs offer a way to invest in these industries and potentially receive tax-deferred returns.

However, the structure of MLPs could be tricky, especially when it comes to taxes. To minimize the risks you may face down the road, consider working with a financial advisor before investing in any MLP.