Understanding Master Limited Partnerships (MLPs): A Comprehensive Guide

Updated on September 19th, 2024 by Bob Ciura

Spreadsheet data updated daily

Master Limited Partnerships (MLPs) are often misunderstood investment vehicles that can offer significant benefits to investors. This article delves into the intricacies of MLPs, exploring their history, tax implications, advantages, disadvantages, and a selection of top-ranked MLPs to consider for investment.

The History of Master Limited Partnerships

MLPs were established in 1981 to allow certain business partnerships to issue publicly traded ownership interests. The first MLP was Apache Oil Company, which paved the way for a wave of energy-focused MLPs. Over the years, the MLP landscape expanded to include various industries, including real estate and even sports franchises like the Boston Celtics. However, energy MLPs have come to dominate the sector, particularly those involved in midstream operations, which include the transportation of oil and gas through pipelines.

MLP Tax Consequences

One of the most appealing aspects of MLPs is their tax-advantaged structure. Unlike corporations, MLPs are pass-through entities, meaning they are not taxed at the entity level. Instead, all distributions made to unit holders are taxed at the individual level. This unique structure allows MLP investors to be classified as limited partners rather than shareholders, and the distributions they receive are referred to as distributions, not dividends.

Distributions from MLPs can be categorized as either:

• Return of Capital: This is typically the bulk of MLP distributions, often around 80% to 90%. Returns of capital are not taxed until the MLP units are sold, effectively deferring taxes for investors.
• Ordinary Income: This portion is taxed in the year it is received.

The tax efficiency of MLPs can lead to a significantly higher after-tax income compared to traditional corporate dividends, making them attractive for income-focused investors.

Important Tax Considerations

While MLPs can be held in taxable accounts, they can complicate tax situations, especially when held in retirement accounts like IRAs or 401(k)s. MLPs generate Unrelated Business Income (UBI), which may require additional tax filings (Form 990-T) if the UBI exceeds $1,000. This complexity can deter some investors, but the potential for tax-deferred income remains a strong incentive.

Advantages & Disadvantages of Investing in MLPs

Advantages of MLPs

1. Lower Taxes: MLPs can generate approximately 40% more after-tax income compared to traditional corporate dividends, depending on the investor’s tax bracket.

2. Tax-Deferred Income: The majority of MLP distributions are classified as returns of capital, allowing investors to defer taxes until they sell their units.

3. Diversification: MLPs provide diversification benefits, often exhibiting low or negative correlation with other asset classes like corporate bonds and gold.

4. High Yields: MLPs typically offer yields significantly higher than the broader market, making them appealing for income investors.

Disadvantages of MLPs

1. Complex Tax Situations: MLPs require K-1 forms for tax reporting, which can complicate tax preparation.

2. Additional Paperwork in Retirement Accounts: Holding MLPs in retirement accounts can lead to extra paperwork and potential UBI tax implications.

3. Limited Diversification Within the Asset Class: Most MLPs are concentrated in the energy sector, particularly oil and gas pipelines, which can limit diversification.

4. Incentive Distribution Rights (IDRs): Many MLPs have IDRs that can reduce the cash flow available to unit holders as the general partner receives a larger share of distributions.

5. Risk of Distribution Cuts: High payout ratios can lead to increased risk of distribution cuts during periods of cash flow decline.

6. Growth Through Debt and Share Issuances: MLPs often rely on issuing new units or taking on debt to fund growth, which can dilute existing unit holders’ ownership or increase financial risk.

The 7 Best MLPs Today

Investors looking for MLPs should consider those with strong fundamentals and growth potential. Below are seven top-ranked MLPs based on expected total returns over the next five years.

MLP #7: AllianceBernstein Holding LP (AB)

• 5-Year Expected Annual Returns: 10.3%
• AllianceBernstein is an asset manager with a focus on fixed income investments and diversified solutions for various clients. The company reported a GAAP net income per unit of $0.99 for Q2 2024.

MLP #6: Enterprise Products Partners LP (EPD)

• 5-Year Expected Annual Returns: 10.6%
• Enterprise Products operates a vast network of pipelines and storage facilities. The company reported a 12% increase in net income for Q2 2024, with a quarterly distribution increase of 5%.

MLP #5: Hess Midstream LP (HESM)

• 5-Year Expected Annual Returns: 12.4%
• Hess Midstream provides midstream services in North Dakota and has long-term contracts that minimize exposure to commodity prices. The company reported a 13% revenue growth for Q2 2024.

MLP #4: Plains All American Pipeline LP (PAA)

• 5-Year Expected Annual Returns: 12.5%
• Plains All American operates a comprehensive network of pipeline and storage assets. The company reported an 11.5% increase in revenues for Q2 2024.

MLP #3: Brookfield Infrastructure Partners LP (BIP)

• 5-Year Expected Annual Returns: 12.5%
• Brookfield Infrastructure is a global leader in infrastructure networks, reporting a 10% increase in funds from operations for Q2 2024.

MLP #2: Brookfield Renewable Partners LP (BEP)

• 5-Year Expected Annual Returns: 13.6%
• Brookfield Renewable operates a large portfolio of renewable power assets and reported a 6% increase in funds from operations for Q2 2024.

MLP #1: NextEra Energy Partners (NEP)

• 5-Year Expected Annual Returns: 18.8%
• NextEra Energy Partners focuses on renewable energy projects and reported solid financial performance, projecting 5% to 8% growth in distributions through 2026.

MLP ETFs, ETNs, & Mutual Funds

Investors can gain exposure to MLPs through various vehicles:

1. Individual MLPs: Direct investment in publicly traded MLPs allows for targeted investment strategies.

2. MLP ETFs and Mutual Funds: These funds provide diversification by investing in a basket of MLPs, reducing individual stock risk.

3. MLP ETNs: Exchange-Traded Notes track the performance of MLP indices and offer a simpler tax structure, avoiding K-1 forms.

Final Thoughts

Master Limited Partnerships represent a unique asset class that can provide substantial benefits for income-focused investors. With their tax-advantaged structure, high yields, and potential for strong total returns, MLPs can be an attractive addition to a diversified investment portfolio. However, investors should be aware of the complexities involved in MLP taxation and the specific risks associated with this investment vehicle.

For those interested in exploring MLPs further, a downloadable list of nearly 100 MLPs, complete with relevant financial metrics, is available.

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