Master Limited Partnerships are publicly traded Limited Partnerships, most often investing in the extraction and transportation of raw materials.
A limited partnership is a limited liability corporate structure which contains Limited Partners, and at least one General Partner. This gives the funds excellent tax advantages. They also have liquidity advantages owing to their listing on public exchanges.
Since they are so little understood, they are a great place to start looking for market pricing disconnects and investment opportunities.
How does a firm become a master limited partnership?
To be able to form as a Master Limited Partnership, a company must make 90% of its money in real estate, natural resources, or commodities.
This income can come from the business itself or any dividends or interest they receive as a result of investing or participating in those areas. Generally, the companies are split into a publicly traded Limited Partner and at least one General Partner.
You can invest in either the Limited Partner, or in some cases the General Partner. General Partners manage the growth of the LP, and once the LP hits a defined Incentive Distribution Rate, distributions increase faster to the General Partner, and the growth in distribution slows down to the Limited Partner.
Of course, you should research heavily about your MLP's structure before buying. Arbitrage opportunities may even become apparent between the two Partners!
How do you avoid double taxation with master limited partnerships?
Most publicly traded companies have a major disadvantage with taxes - they're taxed twice. They pay tax on their earnings, and investors pay tax on any dividends or capital gains from holding equity.
MLPs avoid this weird gotcha in the American tax system... all of their taxes pass through either reinvestment or the limited partners in the firm.
In particular, this means you, as an investor. Income earned in the MLP will flow through to you and be taxed at your marginal tax rate.
Sounds like a raw deal, huh? No.t necessarily MLPs distribute an amount known as the "Distributable Cash Flow".
This distribution includes income, but the amount is often vastly greater than the income the company books.
How does that happen? The partnerships take generous depreciation and tax deductions. The distribution's non-income component is considered a "return of capital" and is not taxed but rather subtracted from the cost basis of the shares (technically, units) which you purchased.
This allows an investor absolute control over tax hits (much like a less predictable version of the traditional 401(k)).
Tax reporting and caveats with MLPs
Taxes are convoluted when it comes to MLPs, and it is important to note they should NOT be held in Roth style accounts (either IRAs or 401(k)s).
"Unrelated Business Taxable Income", must be paid regardless of account status when exceeds $1,000. Read here for more.
MLPs issue a K-1 tax form. If you've never seen one, it's somewhat self-explanatory once you dig into all of the numbers. (Most tax software should be able to handle it).
The most important part of the K-1 is the adjustment to cost basis. Make sure you save all of your documentation somewhere (hopefully you'll avoid some headaches when it's time to sell).
Take a look here for even more detail on the issued K-1s.
An Example of How To Calculate Tax Basis in an MLP
Say you buy 10 shares of a MLP for $50 a share, and hold them for 5 years. Each share distributes $2.50 in cash per year, with $.50 of that taxable income. The share price appreciates at 5% a year.
Cost: $50 x 10 shares = $500.
After 5 years, $63.81 x 10 shares = $638.10.
This $138.10 when you sell is booked as a long term capital gain. Each year reduces the cost basis by $2.
Your final cost basis is $40 per share. This $100 (($50-$40)*10) reduction in cost basis is taxed at your normal tax rate when you sell.
In between: Each year, you are paid $5.00 in income and receive $20.00 in other cash which is taxed when you sell. The $5.00 is taxed yearly.
Should You Invest in Master Limited Partnerships?
If you're not afraid of a little paperwork, MLPs exist in an often overlooked area of the market. Perhaps they are right for you?
You can find a list of MLPs here.