What is an MLP Company? A Beginner’s Guide

Master limited partnerships (MLPs) are a unique type of company structure that combines the tax benefits of a private partnership with the liquidity of publicly traded stocks In recent years, MLPs have become an increasingly popular investment, especially for those seeking steady dividend income However, MLPs have some complexities that distinguish them from regular corporations, so it’s important to understand what they are and how they work before investing in them.

What is an MLP?

An MLP is a publicly traded partnership entity that is a hybrid between a corporation and a partnership Like a corporation, MLP units trade on a stock exchange, providing investors with liquidity However, MLPs are structured as limited partnerships that pass through income and deductions to the limited partners, avoiding taxation at the entity level.

The MLP structure was created in the 1980s by the US Congress to encourage investment in natural resource and energy infrastructure projects. Today, most MLPs operate oil and gas pipelines, storage terminals, and other midstream energy assets. However, the structure is also used by some companies outside of the energy industry.

Key Features of MLPs

Here are some of the key features that distinguish MLPs from regular corporations

• Pass-through taxation – As partnerships, MLPs avoid paying corporate income taxes. Instead, profit or loss is passed through to the limited partners, who pay taxes on their share of the MLP’s income.

• High dividends – MLPs typically pay out most of their cash flow to unit holders in the form of quarterly distributions. Distribution yields often range from 5-10%.

• General partner/limited partners – MLPs have a general partner that operates the business while limited partners provide capital as passive investors. The general partner owns 2% of the MLP units on average.

• Incentive distribution rights – General partners are often entitled to increasing percentages of marginal cash distributions as distribution benchmarks are met, providing incentive to grow distributions.

• K-1 tax statements – Investors receive a K-1 form each year detailing their share of income, deductions, and credits for tax purposes. This can make tax preparation more complex.

• Limited liability – As limited partners, investors have limited liability exposure to the MLP equal to their capital investment.

• Lack of corporate taxes – MLPs avoid corporate taxation, allowing more cash flows directly to limited partners.

Reasons to Invest in MLPs

There are several potential benefits to investing in MLPs:

• High income potential – The high distribution payouts from MLPs can generate substantial income for investors, especially when compared to bonds or dividend stocks. Distribution yields of 6-8% are common.

• Tax-deferred income – Between 20-80% of MLP distributions are typically considered return of capital, enabling tax-deferred benefits for investors. Return of capital defers taxes until the MLP investment is sold.

• Growth opportunities – MLPs that successfully invest in growth projects can increase their distributions over time, providing an income stream that grows.

• Energy infrastructure exposure – Investing in MLPs provides exposure to critical energy infrastructure like pipelines without investing directly in volatile commodities.

• Inflation hedge – MLP revenues and distributions tend to increase along with inflation, providing some protection from rising prices.

Reasons to be Cautious with MLPs

However, there are also some potential drawbacks to consider with MLPs:

• Interest rate sensitivity – Like other high-dividend investments, MLPs can be impacted by rising interest rates which may make their yield less attractive relative to lower-risk investments.

• Tax complexity – The K-1 forms and multi-state filings required can be burdensome at tax time.MLP investors may need to file tax returns in each state where the MLP operates.

• Governance risks – Conflicts of interest are possible between general partners who control the MLP and limited partners who depend on distributions.

• Commodity price exposure – Many MLPs have exposure to volatile oil and gas prices since they operate pipelines, storage assets and other energy infrastructure.

• Lack of diversification – Most MLPs operate in the Energy sector, limiting diversification.

MLP Sectors

While the majority of MLPs operate in the Energy sector, they can technically operate in any qualifying industry. Here are some of the major sectors for MLPs:

• Oil & Gas Production – These MLPs generate income from oil and gas production and exploration assets. Examples include Viper Energy Partners (VNOM) and Dorchester Minerals (DMLP).

• Midstream Energy Infrastructure – The largest MLP sector, including pipelines, storage terminals and other assets that transport, process and store oil, natural gas and related products. Examples include Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP).

• Shipping – Owns and operates marine transportation vessels moving liquefied natural gas, crude oil, refined products and other cargo. Examples include Capital Products Partners (CPLP) and Costamare (CMRE).

• Real Estate – MLP structure can be used for certain real estate activities like owning hotels and resort properties. Examples include Landmark Infrastructure Partners (LMRK) and CorEnergy Infrastructure Trust (CORR).

• Financial Services – Provides services to energy companies or direct lending. Examples include CVR Partners (UAN) and Barings BDC (BBDC).

Best Practices for Investing in MLPs

For investors interested in gaining exposure to MLPs, here are some best practices to keep in mind:

• Focus on larger, financially stable MLPs with proven track records of maintaining distributions through different economic cycles. Smaller MLPs tend to be riskier.

• Consider investing through a diversified MLP fund or exchange traded fund (ETF) to gain exposure to the sector while limiting concentration risk in any single name.

• Understand the tax implications before investing, and hold MLPs in tax advantaged accounts like IRAs if possible. Consult a tax advisor regarding MLP taxes.

• Evaluate the health of distribution coverage and balance sheet leverage periodically to ensure financial stability and distribution safety.

• Consider the risks of rising interest rates, tax policy changes, and economic slowdowns on MLP investments. Factor in appropriate risks when determining position sizing.

Is an MLP Right for Your Portfolio?