Master Limited Partnership (MLP)

What it is:

A master limited partnership (MLP) is a publicly traded limited partnership. Shares of ownership are referred to as units. MLPs generally operate in the natural resource, financial services, and real estate industries.

How it works/Example:

Unlike a corporation, a master limited partnership is considered to be the aggregate of its partners rather than a separate entity. However, the most distinguishing characteristic of MLPs is that they combine the tax advantages of a partnership with the liquidity of a publicly traded stock.

MLPs allow for pass-through income, meaning that they are not subject to corporate income taxes. Instead, owners of an MLP are personally responsible for paying taxes on their individual portions of the MLP's income, gains, losses, and deductions. This eliminates the "double taxation" generally applied to corporations (whereby the corporation pays taxes on its income and the corporation's shareholders also pay taxes on the corporation's dividends).

MLPs make distributions that are similar to dividends, and these are generally paid out on a quarterly basis. It is important to note that cash distributions are not guaranteed, and every unitholder is responsible for the taxes on his or her proportionate share of income, even if the MLP does not pay a cash distribution.

Generally, investors can purchase MLP units from brokers. A unitholder's initial tax basis in MLP units is generally the amount he or she pays for the units. The unitholder's basis is usually then decreased with each distribution and allocation for losses or deductions, and the basis is increased for each allocation of income. A portion of certain distributions may qualify as a return of the investor's capital, thereby reducing the unitholder's taxable basis.

When an MLP pays more in distributions than it earns in taxable income, the unitholder's tax basis is decreased by the difference between the cash received and the MLP's taxable income. When the unitholder sells his or her units, any gain on the sale is taxed at the unitholder's ordinary income tax rate.

MLPs must mail an IRS Schedule K-1 to each of their unitholders every year. This Schedule K-1 reports the unitholder's allocated income, gain, loss, deduction, and credits. If the unitholder's taxable partnership income for the year is negative, then this is considered a passive loss under the tax code and may not be used to offset income from other sources. Instead, the passive loss may only be used to offset future income from the same MLP.

Although unitholders are generally limited in their liability, similar to a corporation's shareholders, creditors typically have the right to seek the return of distributions made to unitholders if the liability in question arose before the distribution was paid. This liability stays attached to the unitholder even after he or she sells the units.

Why it Matters:

The fact that master limited partnerships are not subject to income tax means that more cash is available for distributions than would be available had the company incorporated. This generally makes MLP units worth more than similar shares of a corporation.

The size of an MLP's cash distributions generally drives the value of its MLP units. With this in mind, it is particularly important for investors to carefully evaluate whether an MLP is able to meet its current distribution obligations and whether it will be able to continue (and possibly even raise) its future distributions. If a particular ir sports a distributable cash flow coverage ratio of 1:1, then this generally indicates that the MLP has adequate cash to meet its cash distribution requirements.

As a side note, the American Jobs Creation Act of 2004 added MLP income to the list of acceptable sources of income for mutual funds, with some conditions, including that mutual funds may not invest more than 25% of their assets in MLPs, nor may they own more than 10% of any one MLP.

Before you put a dime in MLPs, be sure to take the time to read one of our most popular articles on the topic: Master Limited Partnerships: A High-Yield Favorite for Growing Dividends. There you'll find more information about what to expect from these securities when you invest.

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