Master limited partnerships are also known as MLPs. The first MLP was organized in 1981 as an alternative corporate structure with unique tax benefits. In 1987, Congress limited the use of the structure to those companies in the real estate and natural resources sectors. These limitations were put into place out of a concern over too much lost corporate tax revenue since MLPs do not pay federal income tax, but rather pass along the tax liability for any profits to the shareholders of the MLP.
We have three learning objectives for this post:
- To understand the potential benefits and risks of investing in MLPs
- How MLPs may provide tax preferred income
- Learn two distinct ways of investing in MLPs
Master limited partnerships are companies engaged in the transportation of natural resources. This can include ocean shipping companies and others, but the asset class is predominated by energy companies which operate the pipelines that transport natural gas and crude oil from the point at which it is brought out of the earth to the places where it is refined and distributed.
In theory, as transmitters of resources, MLPs should not be affected by the price of gas or oil going through their pipelines, as the producing and refining companies have contracts with the MLP for volume to be transported, not the price of the commodity. However, in actual practice, if price swings for the gas or oil get extreme, especially to the downside, investors may fear that some of the producers and refiners may not honor their contracts with the MLPs. This can cause the price of MLPs to drop dramatically. We observed this in the 2015 – 2016 timeframe when oil prices dropped. Again, in early to mid-2020 when oil prices crashed to zero for a few days when economic uncertainty related to the COVID-19 virus and a spat between the Russians and Saudis roiled the energy markets.
While price movements may provide both risk and opportunity. One of the attractive features of MLPs is the relatively high level of income they produce and distribute to their shareholders. Typically, the income from MLPs is at least double or triple the income earned from dividends on common stocks. In addition, the distributions from some MLPs are partially tax sheltered. This benefit is the result of the MLP corporate structure which allows for depreciation of the MLP assets, such as pipelines, pumps and other equipment, to shelter part of the distributions paid to shareholders from tax. This tax benefit is effectively temporary though since the depreciation of assets ends up reducing the MLP shareholders cost basis. This means that when you sell your MLP position in the future, you will have a larger capital gain. This still works in your favor though since capital gains are usually taxed at lower rates than ordinary income.
In recent years, some MLPs have converted to standard C corporation tax status to take advantage of some tax law changes. While the nature of the business is unchanged, owning shares of an MLP that converted to standard corporate structure does not provide the tax benefits described above, but the dividend income is taxed just like dividends from any common stock, at lower rates than ordinary income.
There are two ways to invest in MLPs, whether they have converted to C corporation status or not. You can buy shares of one or more MLPs directly, just like buying shares of any company. If you buy shares of an MLP that still uses the old corporate structure you will receive a K-1 tax form at the beginning of each year which has details of the income you received and how much of it was taxable. You will receive one K-1 for each MLP you own. If you own shares in a firm that converted to C corporation status you will not receive a K-1, but your dividend income will be accounted for on a 1099 form from the brokerage firm where you hold your shares.
One effective way to own MLPs and those which converted to standard corporate structure is to buy shares of a mutual fund or exchange traded fund which invests in this sector. With one purchase of such a fund you can own a diversified portfolio of MLPs and C- corporation pipeline companies. These funds also offer the advantage of not having to deal with K-1 forms at tax time since the income will be accounted for on a standard 1099 form.
In summary, MLPs and C corporations, which build and run the pipeline system that moves energy resources around the country, can be an attractive income producing asset with some tax advantages and the chance for capital appreciation.
If you would like to learn more our investment and financial planning services, including how MLPs can help diversify your portfolio, contact us today at (941) 778-1900 or Click Here to schedule a call.