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master limited partnershipsMaster limited partnerships or MLPs are a way to invest for high yields, beyond traditional stocks and bonds. MLPs can trade on an exchange just like a stock. If you’re looking to shake up your investments, a master limited partnership can help. However, the benefits should be balanced against the risks.

Master Limited Partnerships Defined

Master limited partnerships are essentially partnerships with a twist. They involves two types of partners: general partners and limited partners. The general partners oversee and manage the MLP. Partner compensation hinges on MLP performance, similar to corporate shareholder return. Depending on an MLP’s structure, there may be one general partner or several.

Limited partners purchase shares or units in the MLP. In other words, if you invest in a master limited partnership you’re providing capital for operations. Often, the term “silent partners” refers to limited partners. In exchange for your investment, you receive distributions from the MLP’s income. Typically, distributions pay out quarterly. Limited partner units in the MLP trade publicly. As a result, you can buy and sell them as you would a stock or mutual fund.

According to the Securities and Exchange Commission (SEC), master limited partnership investments generally trade on exchanges. They focus on exploration, development, mining, processing or transportation of minerals or natural resources. For example, an MLP might hold assets like oil or gas pipelines which generate cash flow.

These companies structure themselves as pass-through entities, which means the business itself isn’t subject to income tax. Instead, the income tax liability is passed through to the unitholders or investors. The upside of that is that distributions aren’t subject to corporate tax. They’re only taxed once, at the investor’s ordinary income tax rate. In that sense, distributions from MLPs are similar to the dividends from a dividend-paying stock or mutual fund.

Benefits of MLP Investment

master limited partnershipsMLPs have significant return potential. According to the Alerian MLP Index, which measures energy infrastructure MLPs, they offered an average yield of 10.19% through December 2019. That far outpaced the 1.88% average yield offered by the S&P 500 or even the 3.51% average yield associated with real estate investment trusts.

MLPs can offer better returns to investors than bonds. The latter tend to be more sensitive to rising and falling interest rates. In addition to providing higher yields, MLP returns may offer more stablity and consistency compared to other investments. Often, MLPs involve industries growing slowly but continuously. Investors can benefit from drawing reliable returns from those investments. That can make master limited partnerships lower risk than other investments.

Distributions from MLPs may appeal to investorss seeking regular income. Investors can reinvest those distributions by purchasing more MLP units or making other investments that grow their portfolio. Or, they can supplement withdrawals from a 401(k) or IRA, or Social Security benefits in retirement.

Tax Implications of MLPs

Distributions from master limited partnerships are tax-sheltered since the money comes from a pass-through entity. Both profits and losses pass through to you. As a result, you’re responsible for paying income taxes on any earnings from the MLP. Deductions for depreciation also be pass to investors. However, they can give you a tax break and reduce your taxable income.

An MLP tax filing is somewhat more complicated. Limited partners in an MLP receive a Schedule K-1. It lists all the income and deductions associated with the partner’s holdings. If you’re not exactly sure how to report the information from this form on your tax return, you may need professional help in doing your taxes.

You also may be required to file a state income tax return in the state the MLP is based in, even if you don’t live there. Holding MLP units in a tax-deferred account, such as an IRA, can create additional issues if it generates unrelated business taxable income. That could mean you’d pay taxes on the distributions from those units, even though they’re in a tax-deferred account. Owning MLP units through a mutual fund or ETF could also create a tax burden if those funds are subject to the corporate tax rate.

MLP Makeup

The other risk you’re taking with master limited partnerships stems from the industries they represent. MLPs tend to focus on a handful of industries, so they don’t offer broad diversification. Concentrating a large chunk of your investment portfolio in MLPs could raise your potential risk. If an MLP runs into financial trouble because it has too much debt or an economic slowdown affects profitability, then that could shrink your returns.

There are also bigger issues, such as the increasing shift toward sustainability. As more companies and consumers look toward sustainable energy sources, the pressure for oil and gas companies to adapt and innovate may increase.

How to Invest in Master Limited Partnerships

Since master limited partnerships are traded on an exchange, you can invest in them much the same way you would if you were buying shares of a stock or mutual fund. You can purchase MLP units through a tax-advantaged retirement account, such as an IRA, or hold them in a taxable account through an online brokerage.

When comparing MLPs or MLP funds, take a good look at what drives it. Look at how much the MLP generates and where that money comes from. Ideally, you should be investing in an MLP that has a sustainable cash flow not just right now but for the long term as well.

You should also take into account the cash distributions paid out to investors as well as how much debt the MLP is carrying. A master limited partnership could attract investors with a high distribution yield. But you need to look closer to make sure it’s sustainable.

Finally, consider any internal or external factors that could raise your risk profile when investing in MLPs. Consider how well the MLP is managed, how insulated it is against inflation or interest rate risk and whether it’s being challenged by the emergence of innovative technologies.

The Bottom Line

master limited partnershipsMaster limited partnerships have several attractive features, including the potential for regular cash distributions and high yields. They may not be right for every investor, however. Knowing what you’re investing in and being aware of how MLPs can affect your tax filing are important for deciding whether to add them to your portfolio.

Investment Tips

  • Consider talking to your financial advisor about whether investing in MLPs can help you advance your investment goals. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Also, think about talking to a tax professional to better understand the tax implications of investing in MLPs and how that could increase or decrease your tax liability. A tax expert can walk you through the basics of reporting taxable income from MLPs and what consequences, if any, you may need to be aware of when investing in MLPs in tax-deferred versus taxable accounts. Meanwhile, SmartAsset’s tax guide can help answer some of your more basic tax questions.

Photo credit: ©iStock.com/baona, ©iStock.com/courtneyk, ©iStock.com/SrdjanPav

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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