The Beginner’s Guide to Master Limited Partnerships
Master Limited Partnerships are a business model in the form of publicly traded limited partnership. It brings together the advantages that partnerships provide and the liquidity of a public company. In partnerships, taxation only applies when dividends are being distributed to the partners. Click Here To Go Straight To Our Online Tutorial
MLPs have two types of partners:
Limited partners: These are investors who buy MLP shares and provide the capital that’s required to run the company. They get distributions from MLPs on a quarterly basis.
General partners: These are investors who are involved in the daily running of the business. They are paid according to how well the partnership is doing.
What’s a Master Limited Partnership?
The MLP is a partnership traded on the national exchange. It provides major tax advantages to all of its partners. Since MLPs are designed to use cash flows, they have to distribute any cash that they have to investors. MLPS can minimize the capital cost in businesses that require a lot of capital, for instance, businesses that are in the energy sector.
In fact, a large portion of MLPs can be found in the energy sector. They provide and manage resources. For instance, Genesis Energy is based in Texas and provides plant processing, supply, and logistic support services for companies that are in the oil business.
A lot of oil companies provide MLP shares instead of company stock. This makes it possible for individuals and corporations to own a stake in the company. The probability is that a company will own a stake in its own MLP. Other corporations that issue stock are founded with the sole intention of owning shares of the company. The corporation also distributes passive income as a dividend.
For instance, Linn Energy Inc. has an MLP and a corporation which has a stake in the MLP. Investors are then given the choice of selecting how they prefer to get the income that the company distributes. This is for tax purposes.
The History of MLP Investments
The first master limited partnership stocks were started in 1981. However, Congress limited MLPs in 1987 to real estate companies and the energy sector. These measures were taken in response to what was deemed to be a loss of corporate tax considering that MLPs aren’t required to pay federal taxes. For the MLP to get a pass, 90% of its income needs to be qualifying income. This is income that’s obtained as a result of exploration, production, and transportation of real estate. This is to say that for a company to be classified as an MLP, 90% of its revenue should come from natural resources, commodities and real estate. This description of a ‘qualifying income’ greatly limits the industries in which MLPs can venture into.
Features of an MLP
An MLP is a hybrid of a partnership and a corporation. It’s viewed as a collection of partners and not as a separate legal entity which is the way a corporation is seen. Also, it doesn’t have any employees as it’s the partners who run the business. General partners usually have a 2 percent stake in the partnership, but they have the option of increasing their stake if they want to.
An MLP doesn’t issue shares, but it gives out units instead which can be traded on stock exchanges. This makes the uses quite liquid, and it’s a feature that normal partnerships don’t offer. Since these are not stock, people who buy these units are considered unitholders and not shareholders. People who invest in MLPs are referred to as Limited Partners. They usually get a share of the income made by the MLP.
Have you ever wanted to know how to avoid double taxation? When it comes to taxation, MLPs are treated as Limited Partnerships. In a Limited Partnership, any losses or profits that are made by the business are passed on to the Limited Partners. This means that MLPs are not held liable for corporate taxes as it happens with most companies. Instead, it’s the partners who are held liable for paying their own individual taxes from their MLP earnings. This is quite advantageous since profits won’t be double taxed. Double taxation usually happens in corporate companies, since the companies pay corporate taxes and partners also have to pay taxes on their dividend earnings. Also, depreciation and depletion are also passed on to the partners. This makes it possible for the owners to deduct the depreciation and depletion from their taxable income.
Just like dividends are paid out on a quarterly basis, the earnings of MLPs also get distributed on a quarterly basis. However, they are not handled as income but as return on capital. Therefore; unit holders aren’t required to pay tax on this income. The earnings are not immediately taxed. Rather, taxing takes place later on when the units are sold using the lower capital gains rather than the personal income rate, which is higher. This is quite advantageous when it comes to tax benefits.
MLPs are low-risk investments given that the investment opportunities are slow. This happens because industries they are in are slow, like for example, pipeline construction. The good thing is that you will be able to earn a regular income from them, given that they are longtime service contracts. MLPs are quite good at providing a regular cash flow; therefore, you will get periodic cash distributions. The good thing is that cash distributions come in at a rate that’s faster than inflation rates. Also, 80% of the partners get their income tax-deferred. This makes it possible for MLPs to provide great income gains and double taxation avoidance. In most cases, these gains are much higher than what you would get from the dividend yield of equities. Also, the avoidance of double taxation leads to bigger capital for other projects. This, in turn, gives MLPs a competitive edge.
In the case of limited partners, the snowballing effect of cash distributions often ends up being more than the capital gains taxes that you will have to pay once you sell off all your units.
There are several advantages of using MLPs when planning for the estate. In case you own units, and then you opt to transfer your units to another beneficiary, both of you won’t have to pay taxes during the transfer period. The value of the units will be calculated using the market rate at the time that the transfer is being made. In case the unit holder passes on, then the heirs will get the units transferred to them at the fair market value based on the date of death of the unit holder. Also, their previous distributions don’t get taxed.
One of the major disadvantages of being an MLP unit holer is that you are asked to file a Schedule K-1 form. This form is much more complex to file than the 1099-DIV. That translates to you having to pay your accountant much more than you normally would. This is even when you haven’t made any money from selling your units. Moreover, in most cases, the Schedule K-1 form usually arrives late. This can be quite inconveniencing when you are trying to prepare your tax returns in time.
Furthermore, another disadvantage is that in case you get a net loss, you cannot use this loss to offset your income. You must carry forward any net losses that you make to the following year. Once you finally sell off all your units, then you can deduct these losses from your other income.
Also, another disadvantage is the limited upside potential. However, this is something that can happen since this is an investment that’s expected to generate a steady income flow.
Stay Away from MLPs despite High Dividends
Have you ever wanted to know how to buy MLP stocks? One of the reasons why people find MLPs so attractive is due to the high yields that they provide and because they qualify under the IRS Code.
MLPs can be classified under real estate, finance, and energy. Most MLPs can be found in the energy sector, given that 84% of MLPs are in this industry. There are various subcategories in energy. This includes oil, midstream, gas, upstream and downstream company. Since 2016, MLPs have felt the effect of the variations in the price of oil. The cost of the Alerian MLP declined by 32%. There was a time that it was lower than this, but the price went up after it hit a low of 20.7% in February. This gives MLP investors new confidence. Nevertheless, even if MLPs provide high returns, it’s still best to avoid them.
Unstable Commodity Prices
Many investors think that the cost of oil is directly related to the MLP index. This is not true. According to analysts, the price of commodities doesn’t have an effect on a company that’s involved in oil transportation or in the refining oil business. But when oil prices went down, the energy sector also went down. At the same time, when the Alerian MLP Index went down to 32%, the cost of oil was down by 44.84%. According to available information, it seems that the oil prices are a good indicator of the MLP index. The two seem as if they are highly interconnected. A lot of analysts are of the opinion that commodity prices have stabilized from the trend that was once dividing them. Recently, the price of oil shot up, but according to analysts, the price of oil will still remain unstable for the rest of the year. This instability will have a negative effect on the MLP industry and highlight any weaknesses that are in the balance sheets.
Inflated Distribution Rates
MLPs are quite unstable, unlike other investments that generate income like bonds. This explains why the industry’s main focus is on making high-income payouts to unit holders. In case a company has issues and is not able to make payouts, as usual, this will greatly affect the price of the shares. For instance, when Boardwalk Pipeline Partners Ltd. announced on Feb 10th, 2014, that it would reduce its payouts by 80%, its shares price dropped by 46%.
A lot of analysts are of the opinions that the companies are stretched to their limits and are having problems keeping up with their distribution rates. A Hedgeye Risk Management analyst, Kevin Kaiser, thinks that for MLPs to be a good investment, they need to absorb a lot of the pain in the form of reduced distributions. This puts investors at the risk of running MLPs whose payouts they cannot afford to maintain.
MLPs have to pay out 90% of the cash that they have to shareholders. This means that they have little to no cash. That’s why a lot of MLPs turn to investment banks whenever they need funding to help them fund future projects.
A lot of companies have lots of debts. For instance, Enterprise Products has a debt-to-equity ratio of 106. This is very high for a company that isn’t based on the MLP model. One of the biggest oil companies in the world, Exxon Mobil Corporation, has a debt ratio of 24, which is substantially low. Given their really high leverage, MLPs are very dependent on erratic income streams to keep up with debt payments. During weaker times, weak companies will really struggle and will have to cut out distribution payouts or face bankruptcy.
Are Master Limited Partnerships A Good Fit For Me
The decision as to whether you should include MLPs in your investment portfolio is largely dependent on how open you are, on your tax advisor and how for long you intend to invest. Even though this might not be exactly the best time to invest in MLPs, you should consider doing it in the future.