Some investment advisers call master limited partnerships or MLPs the best kept secret in the investing world. That’s probably a little overstated but there’s no doubt that MLPs can represent a great opportunity for investors to earn a consistent income along with some attractive tax advantages.
But if it were so easy, everybody would do it. That’s why there’s a lot to learn before putting money to work in MLPs offered in the market. Like any other investment, you should never invest in a product that you don’t understand so let’s dive in.
What is it?
A master limited partnership combines the benefits of the limited partnership business entity with the advantages of issuing common stock. Much like real estate investment trusts or REITs, MLPs have to return 90% of their income through interest and dividend payments and be related to natural resources, commodities, or real estate.
What that means to the average investor is that instead of pocketing the profits made by the partnership, an MLP has to return 90% to you, the shareholder and normally those payments are pretty high.
An MLP is awarded some very friendly tax advantages. Among those, instead of paying corporate income taxes and taking those from the dividend payments they pay to the shareholders, they pass those taxes directly to the investors. Each shareholder receives a K-1 form which is similar to a 1099-DIV form where those taxes are calculated in the investor’s return. All of these advantages can make dividend payouts six to twelve percent or even more.
Your Tax Benefit
The investor gets a tax benefit too. When you receive the dividend from the MLP, only ten to twenty percent  of the dividend is actually taxable income. The other eighty to ninety percent is considered a return of capital and is counted toward the cost basis of your purchase. If you paid $50 per share for your MLP and you receive $2 in dividend payments, possibly $1.80 would go towards the price you paid lowering your initial investment to $48.20. That represents an unrealized gain.
This is advantageous because you don’t have to pay taxes on that money until you sell the shares or until you hold it so long that your cost basis becomes zero. You only pay dividend taxes on the other 20 cents per dividend payout. As any investor knows, the longer you can keep the IRS off of your gains, the more money you have in your account to work for you.
Who Should Invest?
MLPs are not generally held by institutional investors because they are either not allowed or because of the K-1 form that would have to go out to each investor, it’s too complicated but they work very well for individual investors. Generally, MLPs should only be held in brokerage accounts. Because MLPs produce unrelated business taxable income that generally aren’t allowed to be held in tax deferred accounts like IRAs, individual investors should only invest with non-IRA funds.
This basic article barely scratches the surface of MLPs and although it’s not necessary to know the detailed corporate structure that comprises a master limited partnership, do some further reading on the particulars of these products. Once you do that, put the MLP in your virtual or paper trading account to see how it behaves in various market conditions before starting a position with real money.