Tax Structure of Master Limited Partnerships – How it Can Benefit MLP Unit-Holders

A master limited partnership (MLP) is a unique investment that combines the tax advantage of a limited partnership with the liquidity of a publicly traded stock, allowing stockholders quickly to buy or sell their stocks. MLPs issue investment units that are traded on a security exchange exactly like shares of any other stock. To qualify as a MLP, a company must generate at least 90% of its income from operations in the real estate, financial services, or natural resources sectors.

The major reason for a company to go into a business structured as a MLP is the tax avoidance. Unlike corporations, master limited partnerships are not subject to double taxation (paying taxes at both corporate and personal levels). The owners of the partnership are taxed only once on their individual portions of the MLP’s income, gains, losses and deductions. On quarterly basis, MLPs make distributions that are similar to dividends to its unit-holders. Unlike dividends, these distributions are not taxed when they are received because they are considered return of principal. That results in higher yield, because the money that would have been paid for income taxes are distributed to investors. Furthermore, the tax law allows companies to amortize or depreciate money that is invested in an asset. MLPs allow those deductions to pass through to the unit-holder, who pays no taxes until decides to sell the investment. At the selling point, the investor has to pay taxes over the realized capital gains (the difference between the sales price and the initial cost). The capital gains are taxed at a lower tax rate and the unit-holders end up paying less overall in taxes than they would if it were considered interest instead.

MLPs contain two business entities: general partners and limited partners. General partners manage the day-to-day operations of the MLP, while limited partners have no involvement in the company’s operation activities but investing capital and obtaining periodic cash distributions in return. Generally, the general partners receive 2% of the whole partnership pie and they have the right to own limited-partner units to increase its ownership percentage. A distinguishing characteristic of MLP is the incentive distributions rights (IDRs). Considering the fact that company performance is measured by the cash distributions to the limited partners, IDRs provide the general partners with a performance- based pay for successfully managing the master limited partnership. The IDRs are structured in such way that for each incremental dollar in cash distribution, the general partners receive higher marginal IDR payments, which can increase the initial 2% distributable cash to higher levels such as 15%, 25% up to 50%.

The fact that master limited partnerships pay no federal and state income tax means that more cash is available for distributions. This makes MLP units worth much more than similar shares of corporation. The value of MLP’s units is determined by the distributable cash flow. Therefore, the majority of MLPs operate in very stable, slow-growing sectors of the energy industry, such as pipelines and storage terminals. These assets produce steady cash flows with little variations that allow the MLP to meet its cash distribution requirements.