How to Invest in MLP Checks and What to Know

Master Limited Partnerships (MLPs) are publicly traded entities structured as partnerships, primarily operating within the energy and infrastructure sectors. These investment vehicles combine the tax benefits of a private partnership with the liquidity of publicly traded companies. Investors in MLPs receive regular cash payments, known as distributions.

Understanding Master Limited Partnerships

A Master Limited Partnership is a publicly traded limited partnership that trades on national exchanges. MLPs have a pass-through tax structure, meaning profits and losses are passed directly to investors without being taxed at the entity level.

An MLP’s structure involves general partners (GPs) and limited partners (LPs). GPs manage operations, while LPs are investors who provide capital by purchasing units, entitling them to periodic income distributions.

To maintain pass-through tax status, MLPs must generate at least 90% of their gross income from qualifying sources. These sources include activities related to the exploration, production, processing, storage, and transportation of natural resources. This confines MLPs to sectors like midstream energy assets, such as pipelines and storage facilities.

MLPs offer stable income streams, often based on long-term service contracts. Their focus on infrastructure assets in the energy sector contributes to predictable cash flows and consistent distributions to unitholders.

The Nature of MLP Distributions

Cash payments received by investors in Master Limited Partnerships are known as “distributions,” not dividends. MLPs commonly pay these distributions quarterly, derived from the entity’s cash flow.

A substantial portion of MLP distributions is often classified as “return of capital” (ROC). This means the distribution is not immediately taxed as income when received, but instead reduces the investor’s cost basis in the MLP units.

Tax deferral from return of capital distributions continues until the investor sells their MLP units or their cost basis reaches zero. If the basis reaches zero, subsequent distributions are taxed as capital gains. This differs from corporate dividends, which are taxed as income when received.

MLPs achieve this tax-deferred return of capital due to non-cash deductions like depreciation, associated with their capital-intensive assets. These deductions reduce the MLP’s taxable income, allowing cash distributions to exceed reported taxable income.

Methods of Investing in MLPs

Individuals can gain exposure to Master Limited Partnerships through several investment avenues:
Direct Purchase: Investors can buy individual MLP units on stock exchanges through a standard brokerage account.
Exchange-Traded Funds (ETFs): MLP-focused ETFs hold a portfolio of various MLP units and trade on exchanges. Some MLP ETFs are structured as C-corporations, simplifying tax reporting for investors by issuing a Form 1099 instead of a Schedule K-1.
Exchange-Traded Notes (ETNs): ETNs are unsecured debt instruments issued by financial institutions, with returns linked to an MLP index. Unlike ETFs, ETNs do not directly own the underlying MLPs, introducing issuer credit risk. They are considered tax-efficient as they typically do not issue Schedule K-1s.
MLP Mutual Funds: These funds pool investor money to buy a portfolio of MLP units. Similar to ETFs, some MLP mutual funds may be structured to simplify tax reporting for investors, often issuing a Form 1099.

Taxation of MLP Investments

Direct investments in Master Limited Partnerships involve specific tax implications. Unlike traditional stock investments that issue a Form 1099, direct MLP investors receive a Schedule K-1 from each MLP they own. This document reports the investor’s share of the partnership’s income, deductions, credits, and distributions.

An investor’s cost basis is adjusted annually. Return of capital distributions reduce the basis, while allocations of income and gains increase it. This adjustment affects the taxable gain or loss when MLP units are sold. If the basis reaches zero, subsequent return of capital distributions become taxable as capital gains.

Holding MLPs in tax-advantaged accounts, such as IRAs or 401(k)s, can trigger Unrelated Business Taxable Income (UBTI). If UBTI exceeds $1,000, the account may be subject to tax on that income. This may necessitate a separate tax filing by the account’s custodian using Form 990-T (Exempt Organization Business Income Tax Return).

Due to the interstate nature of many MLP operations, investors may incur state tax filing obligations in each state where the MLP generates income. This is distinct from an investor’s state of residence and can add complexity to tax preparation, as filing requirements may exist even if allocated income is small.

When MLP units are sold, the transaction is taxed in two ways. The portion of the gain attributable to previously tax-deferred depreciation, known as “recapture,” is taxed as ordinary income. Any remaining gain, representing the appreciation in the unit’s value beyond the recaptured amount, is taxed as a capital gain.