How (and Why) to Invest in Master Limited Partnerships

Master Limited Partnerships are publicly traded Limited Partnerships, most often investing in the extraction and transportation of raw materials. A limited partnership is a limited liability corporate structure which contains Limited Partners, and at least one General Partner. This gives the funds great tax advantages with liquidity advantages coming from their listing on a public exchange. The lack of understanding of MLPs also means they are a great place to start looking for market pricing disconnects and investment opportunities.

How Does a Firm Become A Master Limited Partnership?

To be able to form as a Master Limited Partnership, a company must make 90% of its money in real estate, natural resources, or commodities. This income can come from the business itself or any dividends or interest they receive as a result of participating in those areas. Generally, the companies are split into a publicly traded Limited Partner and at least one General Partner. You can invest in either the Limited Partner, or in some cases the General Partner. General Partners manage the growth of the LP, and once the LP hits a defined Incentive Distribution Rate, distributions increase faster to the General Partner, and the growth in distribution slows down to the Limited Partner. Of course, you should research heavily about your MLP before buying; arbitrage opportunities may even become apparent between the two Partners.

How to Avoid Double Taxation With Master Limited Partnerships

Investing in Oil Transport? (Harvey Barrison)

Most publicly traded companies have the disadvantage of double taxation. They pay tax on their earnings, and investors pay tax on any dividends or capital gains from the stocks themselves. MLPs avoid this weird gotcha in the American tax system… all of their taxes pass through reinvestment or the limited partners in the firm (which means you, the investor).

This means that any income earned by the partnership will come to you, the investor, to be taxed at your rate. Sounds like a raw deal, huh? No. MLPs distribute an amount known as the “Distributable Cash Flow”. This includes income, but is often vastly greater than the income the company books. How? The partnerships take generous depreciation and tax deductions. The non-income part of the distribution is considered a “return of capital” and is not taxed but rather subtracted from the cost basis of the shares (technically, units) which were purchased by an ivestor. This allows an investor to control the timing of tax hits…much like a less predictable version of the traditional 401(k). The taxes are a little convoluted when it comes to MLPs, and it is important to note they should NOT be held in Roth style accounts (either IRAs or 401(k)s. This is because of “Unrelated Business Taxable Income”, which must be paid regardless of account status (the government wants someone to pay for it) when it is higher than $1,000. Read here for more.

MLPs issue a K-1 tax form, which you may have never seen, but nonetheless is somewhat self-explanatory once you dig into all of the numbers. Most tax software should be able to handle the entries in an MLP by the point as well. The important part to note is the adjustment to cost basis. Make sure you save all of your documentation somewhere and hopefully you’ll avoid some headaches when it’s time to sell. Take a look here for even more detail.

An Example of How To Calculate Tax Basis in an MLP

Say you buy 10 shares of a MLP for $50 a share, and hold them for 5 years. Each share distributes $2.50 in cash per year, with $.50 of that taxable income. The share price appreciates at 5% a year.

Cost: $50 x 10 shares = $500. After 5 years, $63.81 x 10 shares = $638.10. This $138.10 when you sell is booked as a long term capital gain. Each year reduces the cost basis by $2. Your final cost basis is $40 per share. This $100 (($50-$40)*10) reduction in cost basis is taxed at your normal tax rate when you sell.

In between: Each year, you are paid $5.00 in income and receive $20.00 in other cash which is taxed when you sell. The $5.00 is taxed yearly.

Should You Invest in Master Limited Partnerships?

If you’re not afraid of a little paperwork, MLPs exist in an often overlooked area of the market. Perhaps they are right for you? Here are a few of the larger MLPs: