Master Limited Partnership (MLP)

A Master Limited Partnership (MLP) is a unique American business structure that is publicly traded on an exchange, just like a stock. Think of it as a hybrid: it combines the tax benefits of a private partnership with the liquidity and ease of trading of a public company. Investors in an MLP are considered partners, not shareholders. Consequently, they buy “units” instead of “shares” and receive quarterly “distributions” rather than “dividends.” MLPs are most commonly found in the natural resources sector, particularly in energy infrastructure like pipelines, storage facilities, and processing plants. To qualify for this special tax status, the U.S. tax code requires at least 90% of an MLP's cash flows to come from qualifying sources, which are predominantly real estate, natural resources, or commodities. This structure is designed to encourage investment in these capital-intensive industries by avoiding corporate-level taxes and passing income directly to investors.

At its core, an MLP's magic lies in its structure and tax treatment. Understanding these two elements is crucial before you even think about investing.

Every MLP has two classes of partners, a setup that defines control and financial interest:

• The General Partner (GP): This is the operator and manager. The GP is responsible for running the day-to-day business, making all operational and strategic decisions. The GP typically owns a small percentage of the partnership (often around 2%) but holds all the power.
• The Limited Partners (LPs): This is everyone else, including individual investors like you who buy units on the open market. LPs provide the vast majority of the capital. In return, they receive quarterly cash distributions and enjoy limited liability, meaning their personal assets are protected from the partnership's debts. LPs have no management role or voting rights.

This is the main event. Unlike a traditional corporation, which pays income tax on its profits before distributing the remainder to shareholders (who are then taxed again on their dividends—a phenomenon known as double taxation), an MLP pays no corporate income tax. Instead, it functions as a “pass-through” or “flow-through” entity. All profits, losses, deductions, and credits are passed directly to the individual partners (both GP and LPs). Each partner then reports their share of the MLP's income on their personal tax return. This is documented annually on a special tax form called the Form K-1, which replaces the more common Form 1099-DIV you'd get from a regular stock. This avoidance of corporate tax is what allows MLPs to distribute a larger portion of their cash flow to investors.

Value investors are drawn to businesses with predictable cash flows and attractive returns. For the right price, certain MLPs fit this description perfectly.

Because MLPs are required to pay out most of their cash flow to unitholders, they have historically offered very attractive distribution yields, often significantly higher than the broader market or government bonds. For an investor focused on generating a steady income stream, this can be incredibly appealing. The cash payout is known as a distribution, and it's the partnership equivalent of a corporate dividend. It represents your slice of the company's operating profits.

Many of the best-run MLPs operate essential energy infrastructure. A pipeline that transports natural gas from a production field to a utility company is a great example. This business model functions like a toll road: the MLP gets paid a fee for the volume of gas that moves through its system, regardless of the day-to-day price of the gas itself. This fee-based, long-term contract structure can create very stable and predictable cash flows, a hallmark of a high-quality business that a value investor can analyze and appreciate.

The high yields come with unique risks and complexities. Ignoring them can lead to nasty surprises.

While the pass-through structure is a benefit for the MLP, the associated Form K-1 can be a major burden for the investor.

• They arrive late: K-1s are notorious for showing up in March or April, long after your other tax documents, often forcing you to file for a tax extension.
• They are complex: A single K-1 can be a dozen pages long and requires careful entry into your tax software or by your accountant, who may charge extra to handle it.
• State tax filings: You may be required to file tax returns in every state where the MLP operates, even if you don't live there.

Be extremely cautious about holding MLPs in a tax-deferred account like an IRA or 401(k). MLPs generate something called Unrelated Business Taxable Income (UBTI). If your UBTI from all sources within your IRA exceeds $1,000 in a year, you will have to pay taxes on it, which negates some of the benefits of the retirement account. This is a trap that catches many unsuspecting investors.

Many older MLP agreements contain Incentive Distribution Rights (IDRs). These are rights that give the General Partner an increasingly larger percentage of the cash flow as the distribution per unit rises past certain targets. While intended to align the GP's interests with LPs, they can become a major drag, making it progressively harder for the GP to raise the distribution for LPs. Pro tip: Many modern MLPs have simplified their structures to eliminate IDRs, which is generally a positive sign for LPs.

MLPs are not immune to market forces.

1. Interest Rate Risk: As high-yield investments, MLPs often compete with bonds for investor capital. When interest rates rise, the fixed income from safer government bonds becomes more attractive, which can put downward pressure on MLP unit prices.
2. Commodity Exposure: While many MLPs have fee-based contracts, they are not completely insulated from commodity prices. A prolonged slump in oil or gas prices can lead to lower production volumes from their customers, which means less product flowing through their pipelines and reduced demand for new infrastructure projects.