How to Invest in Master Limited Partnerships (MLPs)

Master Limited Partnerships (MLPs) are publicly traded partnerships, primarily focusing on capital-intensive industries. They combine tax advantages with the liquidity of publicly traded securities, allowing them to pass through income and expenses directly to investors.

Understanding Master Limited Partnerships

Master Limited Partnerships are business structures that trade on national stock exchanges, similar to corporate stocks. An MLP is organized as a partnership for tax purposes, yet its units can be bought and sold in the public markets.

MLPs consist of two main types of partners: a general partner (GP) and limited partners (LPs). The general partner manages the MLP’s day-to-day operations and holds a minority interest. Limited partners are the investors who provide capital by purchasing units in the partnership. These limited partners do not participate in the daily management of the MLP and have liability limited to their capital contribution.

MLPs are “pass-through” entities for federal income tax purposes. This means the MLP itself does not pay corporate income taxes. Instead, income, gains, losses, deductions, and credits are passed directly through to the individual unit holders, who then report these items on their personal tax returns. This pass-through treatment avoids the double taxation that occurs with traditional corporations, where profits are taxed at the corporate level and again when distributed to shareholders as dividends.

To qualify as an MLP and retain this pass-through tax status, the entity must generate at least 90% of its gross income from “qualifying sources.” These sources are primarily related to natural resources and real estate activities. The majority of MLPs operate within the energy infrastructure sector, engaging in activities such as the exploration, production, and transportation of crude oil, natural gas, and refined products.

Investors in MLPs hold “units” rather than shares, and they receive “distributions” instead of dividends. These distributions are paid quarterly and often include a component known as “return of capital.” The partnership agreement outlines how cash flow is distributed to partners.

Investment Approaches for MLPs

Investors can gain exposure to Master Limited Partnerships through several distinct avenues.

A direct purchase of MLP units is one common approach, where investors buy individual MLP units on national stock exchanges through a brokerage account. This process is similar to buying shares of a corporation. Investors select a specific MLP and place an order through their broker, becoming direct limited partners in the entity. Direct ownership provides direct exposure to the performance of the chosen MLP, and the investor receives distributions directly from the partnership.

Another method involves investing in MLP Exchange-Traded Funds (ETFs). These funds hold a portfolio of MLP units, offering investors diversification across multiple MLPs within a single investment. MLP ETFs trade on stock exchanges like individual stocks, making them readily accessible through brokerage accounts. Many MLP ETFs are structured as C-corporations for tax purposes, meaning the fund itself pays corporate income taxes. This structure allows the ETF to issue a Form 1099 to investors for tax reporting, simplifying the tax process compared to direct MLP ownership.

MLP mutual funds offer another route for diversified exposure to the MLP sector. These are actively managed funds that invest in a collection of MLP units. Investors can purchase shares of MLP mutual funds through brokerage accounts or directly from fund companies. Similar to ETFs, some MLP mutual funds are structured to simplify tax reporting for investors by issuing a Form 1099 instead of a Schedule K-1. Funds structured as regulated investment companies (RICs) generally limit their MLP exposure, often to a maximum of 25% of their assets, to maintain their pass-through status for tax purposes. However, funds that primarily hold MLPs and exceed this 25% threshold are structured as corporations and pay taxes at the fund level.

Taxation of MLP Investments

Investing in Master Limited Partnerships involves specific tax implications that differ significantly from traditional stock investments.

The most notable tax document for MLP unit holders is Schedule K-1 (Form 1065), which is issued by each MLP an investor holds. Unlike the Form 1099 received for corporate stock dividends, the K-1 details an investor’s share of the MLP’s income, deductions, losses, and credits for the tax year. This document contains various boxes reporting items like income, deductions, and credits. Investors receive K-1s later in the tax season compared to 1099s, often by mid-March, which can sometimes delay tax filing.

A concept for MLP investors, particularly those holding units in tax-advantaged accounts like Individual Retirement Accounts (IRAs) or 401(k)s, is Unrelated Business Taxable Income (UBTI). UBTI is income generated by a tax-exempt entity from a trade or business not substantially related to its exempt purpose. Since MLPs operate businesses like pipelines, the income generated is considered UBTI when held in a tax-exempt account. If an investor’s total UBTI from all sources across all tax-advantaged accounts exceeds a specific filing threshold, the tax-advantaged account is required to file IRS Form 990-T. This filing obligation and potential tax liability can be a complex aspect of holding MLPs in such accounts.

The cost basis of MLP units is dynamic and requires careful tracking. Unlike corporate stock, where the cost basis remains static unless more shares are purchased or sold, an MLP’s cost basis is adjusted annually based on items reported on the Schedule K-1. Distributions received from an MLP, particularly those categorized as a return of capital, reduce the investor’s cost basis. Conversely, an investor’s share of the MLP’s taxable income or losses will either increase or decrease the basis. These adjustments affect the calculation of capital gains or losses when the MLP units are eventually sold. The K-1 package includes a sales schedule to assist investors in calculating their adjusted basis and the resulting gain or loss upon sale.

Due to the multi-state operations of many MLPs, investors may incur state tax filing obligations in various states where the MLP conducts business, even if the investor does not reside in those states. The Schedule K-1 package often provides a breakdown of income allocated to each state. While the actual tax liability in non-resident states might be minimal, some states require a filing regardless of the amount, adding to the administrative complexity for investors.