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Master Limited Partnerships (MLPs)

by Harry Domash

How to Find the Best MLPs MLP Tax & Liability Considerations MLP Directory

Master Limited Partnerships are similar to real estate investment trusts in that they do not pay income taxes, and their shares trade on the major stock exchanges just like regular stocks. However, REITs and MLPs are different in structure. Unlike REITs, which are a special type of corporation, MLPs are partnerships. An MLP’s general partner is responsible for running the partnership, and individual investors are limited partners.

Master Limited Partnerships get special tax treatment. An MLP does not incur income taxes. Its income is allocated among all partners in proportion to their ownership interest. To qualify for the tax benefit, 90% of an MLP’s income must come from activities in real estate, commodities, or natural resources such as mining, timber or energy production and related activities. However, MLPs may not be suitable for IRAs and other tax-sheltered accounts. Be sure to review the Tax & Liability Considerations section before you buy.

Limited Liability Company (LLC)
A “Limited Liability Company” or LLC has no master partner to take a cut off the top. All of the profits go to unitholders. Thus, in theory at least, LLC distributions should grow faster than similar MLPs. In practice, however, it's difficult to find examples where that has actually happened. For tax purposes, LLCs are treated the same as MLPs.

We’ve divided the Master Limited Partnership and LLC universe into the following categories:

Pipeline Operators

The special tax treatment afforded MLPs seems to have a special appeal to major oil and natural gas producers. Many of them have transferred their petroleum and natural gas pipeline assets to MLPs that the oil companies control as general partners.

Within pipelines, we have crude oil/refined products (gasoline, heating oils) pipelines and natural gas pipelines.

Crude oil pipeline operators enjoy a stable business. Their fees are regulated and are based on the volume of product transported, not by the price of oil. So while earnings may dip if the winters are too warm, or the summers too cool, long-term, earnings growth reflects expansion activities.

By contrast, natural gas pipeline operators often also operate gas-gathering systems, which connect individual wells to public pipelines, which then connect to processing plants. Typically, gathering and processing contracts do expose pipeline operators to changes in the price of natural gas and its byproducts. So, natural gas pipeline operators’ profit margins can vary with the price of the commodity. Some operators employ hedging strategies to reduce their susceptibility to price swings. But not all do because that limits their upside potential.

We also have a diversified product pipeline category for firms operating both natural gas and crude oil pipelines.

Propane Retailers

These partnerships sell propane and/or heating oil products to residential, commercial, industrial and agricultural customers. Except for Inergy, which is an aggressive acquirer, most propane retailers are relatively slow growers.

Exploration & Production

Exploration and production partnerships generally produce crude oil, natural gas, or coal from reserves that they own. The only exceptions are coal mine owners Natural Resource Partners and Penn Virginia Resource Partners. They own the mines, but contract with others to do the digging.

Most oil and natural gas exploration and production partnerships are new to the game and have yet to produce consistent and predictable cash flow growth.

Shipping

Shipping partnerships fall into two groups. Some provide specialized oil or refined product transportation services in U.S. coastal areas, and the others are conventional oil tanker operators.

Real Estate Property & Finance

This is a diverse group. One invests in tax-exempt mortgage revenue bonds, another owns apartment communities, and the third provides financing to apartment developers.

Other Businesses

An interesting collection of partnerships that don't fit neatly into the other categories. Some are intriguing energy plays, while others, such as an amusement park operator and an investment manager, are in entirely unrelated businesses. Those would not be allowed MLP status under current law, but were already in business before the current rules were enacted and are allowed to continue operating.

General Partners

As mentioned, MLPs are controlled by a general partner. The GP typically holds a 2% general partner interest in the MLP plus additional limited partner units.

Typically, the general partner is entitled to a percentage of the MLP’s cash flow off the top, that is, before the limited partners get their distributions. That percentage, called “incentive distribution rights,” or IDRs, varies with the total amount of distributable cash flow earned each quarter. The IDR may start at a low percentage, say 5%, but then ramps up to as high as 50% as distributable cash flow grows.

Most general partnerships are privately held, but a few are publicly traded. In those cases, the general partner typically pays most of its IDR cash to its shareholders.

Over time, because its IDR percentage increases, the general partner’s dividends grow faster than the distributions to MLP unitholders. On the downside, general partner’s yields run in the 3% to 4% range instead of 5% to 7% for many MLPs. Nevertheless, because their dividends grow faster, general partners’ total returns typically exceed the corresponding MLP returns.

General partners may be organized as regular corporations, or as MLPs. When they are organized corporations, shareholders avoid the tax reporting issues that discourage many investors from considering MLPs.

See the complete list of MLPs and General Partners in the Master Limited Partnership Directory

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