An MLP – one of a seemingly infinite number of investing acronyms – is a very popular type of investment for dividend and income investors. And that’s with good reason. You see, MLPs stand for Master Limited Partnerships. MLPs are publicly traded business entities that pay mandatory, regular dividends.
An MLP is similar to a REIT in this regard, in that they both pay income by contract and receive special tax treatment for doing so. But in order to be considered an MLP, a company must be involved in particular types of business, mostly pertaining to natural resources and commodities like petroleum and natural gas. As a matter of fact, 90% of an MLP’s income must come from these industries. But unlike a REIT, which is required to distribute 90% of its income to shareholders, an MLP only has to distribute the amount set forth in the partnership agreement – but that amount can increase.
In an MLP there are two types of partners: the limited partner, which can be a person or group of persons that provide the capital, and the general partner who manages the partnerships business activities and is compensated for the performance of the partnership. This is important for investors to understand because the higher the quarterly distributions paid to limited partners (us shareholders), which results from the successful operation of the businesses, the higher the management fee paid to the general partner. Which is plenty of incentive for the general partner to do a good job managing the partnership’s business activities.
MLPs: Benefits and Drawbacks
But before you invest in MLPs, you have to understand that the distributions are not necessarily tax advantaged to the shareholders. The partnership derives tax benefits because of the business structure, but for shareholders it’s not so clear cut. Frankly, the tax structure is more than a little bit complicated – so most investors should seek the counsel of a tax professional when dealing with MLPs.
You see, a portion of MLPs distributions can be tax-deferred, but the income reporting requirements can be cumbersome. An MLP will let you know how much of each distribution is not subject to ordinary income taxes, but that number will vary.
You’ll get a K-1 tax form each year which breaks down the tax treatment of the prior year’s distributions. And you may get to subtract part of the cash distributions from your original purchase price, lowering your cost basis. But while some of your gains could be taxed at a lower capital gains rate, other gains may still be be taxed as ordinary income. It can be complicated, but do not let that dissuade you from considering an MLP. As a source of diversification and significant income, MLPs should be familiar to all investors.
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