One of the first principles of investing is to diversify your portfolio, spreading out your resources in order to achieve a balance of risk and return.
The best possible scenario is an investment structure that promises high yields without the greater risk that often accompanies it.
How does a Master Limited Partnership work?
Master Limited Partnerships (MLPs) are unique in that they share the characteristics of both partnerships and corporations.
Like corporations, they are traded publicly on exchanges along with stocks and bonds, but unlike corporations, they are not considered discrete legal entities.
Partnerships are composed of a general partner, who manages operations, and limited partners, who are not involved in the running of the business and only provide capital.
Because MLPs are considered simply the aggregate of the partners, they are not subject to corporate tax. Unlike stock dividends, which are double taxed, distributions from MLPs are subject only to income tax when they are paid out to partners.
Since 1987, MLPs have been restricted to slow-growing industries like energy and other natural resources as well as certain types of real estate. While there are no dramatic payouts from such investments, they do offer consistent income and long-term growth.
Why should you invest in an MLP?
If you are just beginning to invest and have your eye on a comfortable retirement, the steady returns from an MLP are a great way to add to your portfolio.
The returns may be modest compared to some investments, but they do offer a better return than bonds without a direct increase in risk.
Because MLPs are publicly traded, investors have the advantage of the liquidity of a stock, so they can cash out quickly if necessary. Distributions from MLPs are also generally just ahead of inflation, so the investment continues to increase in value while the business remains operational.
What are some of the tax benefits?
Limited partners can further reduce their taxable income by deducting any depreciation and depletion undergone by the MLP.
A significant portion of the earnings is also tax deferred until a partner sells their holdings, at which point they are subject to capital gains tax at a rate lower than that of personal income tax.
These greater earnings can also be returned to the MLP as capital, ensuring that it continues to grow, yielding larger distributions.
What are the limitations of MLP investments?
For an MLP to be exempt from corporate tax, 90 percent of its income must be “qualifying,” meaning that it must be derived from the energy and commodities sector, which makes for quite a limited pool that doesn’t allow for much diversification.
Because so many MLPs are in the energy sector, their success or decline has a direct relationship with the price of oil, which can create instability.
Perhaps the greatest drawback for many investors is how complicated their tax returns can get as a result of investing in an MLP.
Filing taxes becomes significantly more complex, and in some situations, investors can incur extra tax costs — such as tax on unrelated business — that may cancel out any gains from the tax shelter.
The bottom line
MLPs can be a valuable component of a diverse investment portfolio, particularly for those who are just beginning to build one. For those interested in a long-term investment with a consistent stream of income, MLPs may be just the thing.
