By: Dr. Jeff Jones
As interest rates have hovered near record lows for nearly a decade, many investors have increasingly sought alternatives to fixed-income securities in order to provide them with steady cash flow. One such investment alternative is something called a master limited partnership, or MLP.
MLPs are an alternative to the traditional corporate form. To qualify to use the MLP organizational form under IRS guidelines, an entity must derive at least 90 percent of its income from specific sources. Among these sources are activities related to the mining, transportation and storage of natural resources. As such, the majority of MLPs in the U.S. are formed in the energy sector.
There are several advantages to investing in MLPs. The first benefit, which is perhaps the most attractive feature to many investors, is that MLPs typically pay very high yields. This may provide the investor with a relatively stable series of cash flows that is higher than what can be achieved by investing in bonds or dividend-paying stocks.
A second benefit is the potential tax advantages of the MLP. Since MLPs are organized as a partnership (instead of a traditional corporation), they avoid the issue of double taxation. The MLP does not pay income taxes, but the gains are instead passed through to the partners (which are called “unitholders” in the case of MLPs). Moreover, the structure of MLPs can often lead to a majority of the cash flow received by investors being treated as a return of capital (instead of dividends), and frequently the cash flow received can be offset by other tax deductions such as depreciation or energy tax breaks.
A third advantage is that MLPs are generally publicly listed securities that trade on major stock exchanges, such as the NYSE and NASDAQ. Since MLPs are publicly listed, it is generally much easier for an investor to sell their interest in an MLP versus an interest in a traditional partnership.
Despite the advantages, there are several risks associated with MLP investment. First, since MLPs are highly concentrated in the energy sector, an investor should not plan to devote their entire portfolio to MLP investment. Additionally, if energy stocks are also part of an investor’s portfolio, investing in MLPs may lead to overexposure to the energy sector.
Second, despite the fact that units of MLPs are publicly traded, there can still be issues with liquidity. The volume of trading in MLPs is generally much lower than that of stocks, hence investors may not be able to sell their units in a timely fashion at a reasonable price. This is particularly true in times of financial market stress, or when credit markets dry up. MLPs generally distribute most of their cash to investors, so they rely heavily on credit markets to provide them with cash.
Finally, there is added tax complexity for investors with investments in MLPs. Since the investor is technically a partner, they will receive a K-1 partnership form, which is more complex than a Form 1099 used to report the receipt of stock dividends or interest income. Moreover, if the MLP produces its income in multiple states, the investor may be required to file multiple state income tax returns.
To determine if MLPs are an appropriate investment for your situation and portfolio, consult with your financial and tax advisers.
Jeff Jones, CFA, CFP, CPA, CMA, CFM is an assistant professor of finance at Missouri State University. The views expressed in this article reflect those of the author, have been distributed for educational and informational purposes only, and should not be construed as investment advice or a recommendation of any specific security, strategy or investment product.
This article appeared in the November 21st edition of the News-Leader and can be accessed online here.