This article is about Master Limited Partnerships. For the article on the company with ticker MLP, see Maui Land & Pineapple Company (MLP).
MLPs are not like regular corporations and do not get taxed on income. Instead they tend to return most of their income (typically 85 to 90%) to investors or partners through quarterly distributions. This shifts the tax responsibility to the partners, who are taxed at their ordinary income rates. Since ordinary income rates of investors are typically lower than the income tax rates of corporations, this proves to be advantageous to the MLPs and hence their investors.
A Master Limited Partnership (MLP) combines the tax benefits of a limited partnership with the advantages of a publicly-traded company. When you compare that rate against the rate you paid for your 2007 personal income, the tax advantages of MLPs are laid out in sharp relief.
Limited partners are only liable for the amount they've invested, unlike general partners who have unlimited personal liability. Limited partners invest capital and then receive the tax benefit of a personal income tax deduction for part of the loss during the development stages of the partnership when the costs exceed any revenues. Limited partnerships are common when businesses are in development stages, but MLPs are unique in that their units are traded publicly like stock, creating much more liquidity for investors.
Distribution income from MLPs is treated differently from dividend income from most stocks. At the end of the tax year, MLPs issue a Schedule K-1 to their investors that shows their share of the MLP's income and deductions. If the MLP pays out distributions in excess of the net taxable income it generates, as reported on the K-1, the distribution is classified as a "return of capital" and tax deferred until you sell your shares or units. Generally, an MLP's distributions will substantially exceed taxable income. Please note that income from MLPs is often taxable even in retirement accounts like 401Ks and IRAs if the income exceeds $1,000. Hence investors tend to shy away from MLPs in retirement accounts and they are also not preferred by institutions.
Master limited partnerships are restricted by the U.S. government to natural resource companies and some real estate enterprises. However, there are certain indirect methods of investing in MLPs and avoiding the tax complications. The MLP Kinder Morgan Energy Partners (KMP) also has a counterpart called Kinder Morgan Management (KMR) that holds units of KMP and whose quarterly payout is treated like a regular dividend instead of a partnership distribution. Another alternative is closed-end funds like Kayne Anderson MLP (KYN) and BlackRock Global Energy and Resources Trust (BGR). KYN is currently trading at a 15.22% premium to net asset value (NAV) and a yield of 9.17%. In contrast BGR is trading at a 13.16% discount to NAV and a yield of 8.61%.
Most MLPs tend to be concentrated in the energy sector but there are always exceptions such as the private equity firms The Blackstone Group (BX) and Fortress Investment Group (FIG), which also happen to be set up as MLPs.
The partners (KMP) have to pay out all of their earnings. So the only way any MLP can get cash is to borrow it, or sell something. Kinder partners (KMP) have to accumulate the cash as if we were paying in cash, so it’s really equivalent to a giant DRIP program, which leaves a lot of cash at KMP.
Investors in the Kinder management (KMR), do not receive cash distributions, but receive shares proportional to the ownership interest they have in the stock. This allows Kinder partners (KMP) to issue Kinder management (KMR), shares, and retain that cash.
The cash distributions for Kinder partners (KMP) and the Kinder management (KMR), are equal; the only difference is that Kinder management (KMR), distributions are paid in the form of additional shares, reducing the need for the Kinder partners (KMP) to raise public equity, or borrow funds.
Rather than receiving and distributing cash, Kinder management (KMR), receives and passes through a dividend in shares known as paid-in-kind distributions. Kinder partners (KMP) the cash that would have been paid out as dividends, to buy assets from Kinder Morgan incorporated (KMI), and finance acquisitions internally.