How to Invest in an MLP: Benefits and Risks

If you’re considering investing money in energy-based companies, master limited partnerships (MLPs) are a way to do that. MLPs, which are often in the oil and gas or renewable energy industries, combine the tax and liability benefits of limited partnerships with the liquidity benefits of a public corporation.

Because MLPs are publicly traded entities, it’s easy to get started investing. However, there are also unique characteristics and risks associated with them, and it’s important to understand those before adding them to your portfolio.

Learn more about MLPs and whether they would be a good fit for your portfolio.

What is an MLP?

A master limited partnership (MLP) is a business enterprise that operates as both a publicly traded entity and a limited partnership. Like other limited partnerships, MLPs have one or more general partners who manage them, as well as limited partners. The limited partners, which you would be if you invested in one, have no role in the business operations and have limited financial liability — you can’t lose more than you invest.

The first MLP was introduced in 1981, and the tax-friendly enterprise gained popularity gradually over the years. However, the Tax Reform Act of 1986 limited the use of MLPs to only those businesses with at least 90% of their income generated from natural resources, commodities, or real estate. Today, the majority of MLPs are in the energy sector, primarily in the oil and gas industry.

How to invest in an MLP

MLPs are publicly traded companies, which means they’re as easy to invest in as any other public company. You can buy and sell them similar to buying and selling shares of a stock, but these are referred to as units. directly from your online brokerage account. However, there are a few things to do before you start investing:

1. Choose a type of MLP

Because of their requirements, the majority of MLPs are in the energy sector. However, there are several different types of MLPs, categorized by either the type of work they do or the type of resources they work with. For example, you can find MLPs that fall along the energy supply chain, including:

• Pipeline MLPs
• Gathering and processing MLPs
• Exploration and production MLPs
• Specialty MLPs

As you look at energy sector MLPs, consider how dependent on commodity prices, such as the price of oil, the MLP is. An MLP that’s more dependent on commodity prices could be more volatile. There are also MLPs involved with commercial real estate, though they’re less common since many of these businesses operate instead as real estate investment trusts (REITs).

2. Read the MLP’s financial statements

Every publicly traded company is required to file financial statements with the U.S. Securities and Exchange Commission (SEC). These statements provide important information about the company to current and prospective investors.

You can look up the financial statements of any public company using the SEC’s EDGAR system. There, you can find an MLP’s prospectus (Form 424), annual report (Form 10-K), and quarterly reports (Form 10-Q) before buying any units.

If you want to know more about an MLP before investing, a financial advisor can help you get more information about any MLP you’re considering. The Institute of Business Finance shares a list of questions you or your advisor should ask about an MLP.

3. Consider your portfolio diversification

Any time you’re considering adding a new asset to your portfolio, it’s important to consider how it will fit in with your existing investment portfolio.

Make sure to consider how much of your portfolio you’ll allocate toward MLPs, the risk tolerance of your existing portfolio (and how adding MLPs would change that), and your overall investing goals, including how MLPs can help you reach those goals.

Once you weigh the pros and cons and have a solid understanding of how MLPs work, you can proceed with adding them to your portfolio.

How do MLPs work?

In some ways, MLPs work just like other public companies. For example, you can buy and sell shares in your brokerage account. However, there are also some important differences related to liability, taxation, and more.

Liability and Ownership Structure in MLPs

There are two types of investors in MLPs: general partners and limited partners.

General partners manage the MLP's day-to-day operations. They have a stake of ownership in the MLP that usually amounts to at least 2% and can be increased if they choose. The general partner has the first priority of cash distributions, but also unlimited liability.

Limited partners are all the outside investors who hold an interest in the MLP (so that’s you, if you decide to invest). Your investment in the MLP helps keep the operation running. Limited partners have limited liability — you can’t lose more than you’ve invested.

Whereas public company stock is sold in shares, MLPs are sold in units. So, if you’re a limited partner, you’re referred to as a unitholder, not a shareholder. However, you could sell your units on the stock exchanges much like you would sell shares of a company.

Tax treatment for the MLP

A key defining characteristic of MLPs is their pass-through taxation, which they enjoy as long as 90% of their income comes from qualifying sources, which we discussed earlier. In other words, the MLP doesn’t pay taxes in the same way that corporations do.

Limited partners receive quarterly distributions (also known as MLP checks) from the MLP. Thanks to the pass-through taxation nature of MLPs, these distributions may be higher than they would be for a traditional corporation that pays taxes on its profits.

Tax treatment for investors

Cash distribution payments to limited partners can be classified in two ways: as income or as a return of capital. If they are classified as income, then the unitholder is subject to federal and state income tax, similar to many dividends from typical corporations.

On the other hand, if the distribution payment is classified as a return of capital, it is only subject to taxation when the limited partner sells the units. Any profit on the unit sales would be subject to capital gains tax. This could be advantageous for the investor because the long-term capital gains tax rate is typically lower than the income tax rate.

Limited partners receive an annual Schedule K-1 statement from the MLP, which outlines the unitholder’s share of the MLP’s income, deductions, credits, gains, and losses. As a limited partner, you would include this information on your annual tax return. The MLP also files a copy of the K-1 form with the IRS.

MLPs vs. other business structures

MLPs share some characteristics with several other business structures. For example, pass-through taxation is something MLPs share with sole proprietorships and limited liability companies (LLCs). C corporations, on the other hand, must pay corporate taxes before they can pass along any of their profits to shareholders.

The limited liability of MLPs is similar to the limited liability of LLC owners, as well as individual shareholders in corporations. However, unlike those other structures, MLPs have a general partner that doesn’t have limited liability.

Pros and cons of MLPs

Investing in MLPs comes with some advantages, but there are also some downsides to consider.

Pros

• Pass-through taxation: MLPs aren’t subject to corporate taxes. Not only does this save the company money, but it allows more of the profits to be passed along to investors.
• Deferred taxes: A portion of your MLP distributions are a return of capital, meaning they aren’t immediately subject to taxation. And when you do pay taxes on them, you’ll pay capital gains taxes instead of income taxes.
• Higher liquidity: MLP units have more liquidity than private limited partnerships, making it easy to sell your investment at any time.
• More transparency: As public companies, MLPs must file financial statements with the SEC, allowing for more transparency. There’s also more price transparency since the units are listed on public exchanges.

Cons

• Slow return on investment: MLPs focus on industries that typically have slow growth, such as oil exploration and pipeline construction. And since MLPs distribute the majority of their income to investors, there’s less available for business growth.
• Complex structure: MLPs have a complex liability and tax structure. While some of these features — pass-through taxation, for example — are beneficial to investors, they also make the investment more difficult to understand.
• Volatility: MLPs historically experience more volatility than traditional stocks and bonds. However, past returns aren’t necessarily a guarantee of how an investment will perform in the future.
• Industry-specific risks: Because most MLPs are in the energy industry, they face some unique risks, including the possibility of legislation or regulations that impact these industries.

Are MLPs right for you?

Investing in MLPs isn’t right for everyone. Here are a few specific types of investors who MLPs may be best suited for:

1. Investors looking for long-term, passive income. You receive quarterly distribution payments and don’t have to pay income taxes on all of your payments in the same way you might with other recurring investment income.
2. Investors who work with (or plan to work with) tax or financial professionals. Because of the tax and structure complexities of MLPs, many investors work with a wealth manager to purchase their units and a tax professional to handle the tax implications. It’s unlikely you’d want to handle all of this on your own.
3. Investors who don’t need their investments in a retirement account. Since MLPs generate unrelated business taxable income (UBTI), they aren’t an ideal investment for your pension, 401(k), IRA, or other tax-exempt investment funds. They often aren’t available in these accounts anyway.

FAQs

Bottom line

Investing in the oil and gas industry or putting your money behind renewable energy companies may be a wise choice and offer diversification for your investment portfolio. MLPs offer a way to invest in these industries and potentially receive tax-deferred returns.

However, the structure of MLPs could be tricky, especially when it comes to taxes. To minimize the risks you may face down the road, consider working with a financial advisor before investing in any MLP.