Most business owners would agree that taxes kinda suck. Okay, they really suck. That’s because most business owners face the dreaded double taxation — paying your own individual taxes AND any corporate taxes. It seems like all of the money your business earns just goes straight to Uncle Sam.
However, believe it or not, there are completely legal ways around this. It all depends on the way your business operates.
Enter master limited partnerships (MLPs).
While you’ll need to have a minimum of two partners in the business and work within specific industries, MLPs provide a considerable tax incentive. Let’s dive into what qualifies as an MLP and the pros and cons of entering into one.
The Short Version:
- Master limited partnerships are companies with at least two publicly traded partners on an exchange but aren’t subject to corporate taxes, just individual taxes.
- MLPs must earn most of their income from business activities within the real estate, natural resources, and commodities industries.
- Investors need to understand that because MLPs are pass-through entities, they pass on the tax burden to their investors, who must, in turn, pay income tax on their MLP earnings.
What Are Master Limited Partnerships (MLPs)?
Master Limited Partnerships are publicly traded companies with tax benefits similar to a limited partnership. Let’s break that down a bit:
- A limited partnership is a business with at least two or more partners.
- Limited partnerships are known as pass-through entities when it comes to taxes. Unlike other businesses where the business and the owner are each taxed separately, pass-through entities are not subject to corporate or business tax. This saves the business owners from getting taxed twice (we’ll go into this more in just a minute).
So, how do master limited partnerships differ from limited partnerships? Limited partnerships are private, while master limited partnerships are traded on a public market.
There also needs to be at least two partners in an MLP. One, known as a general partner, is the one who runs the day-to-day business and makes all of the management decisions. The other types of partners (or partners) are limited partners who don’t have to take on a management role but help fund the business.
How Do Master Limited Partnerships Work?
MLPs have very specific structures and don’t operate exactly like other investment options. They have strict requirements and complicated taxes.
Management and Investors Both Hold Stake in the Company
As mentioned above, MLPs have a general partner who runs the operation and at least one limited partner who invests financially. These limited partner(s) won’t take part in the running of the company.
How exactly do silent investors earn a return? They’re typically paid in quarterly dividends from the company’s earnings. These returns are often above average, too. Many MLPs generate returns above 10%, on average.
The Company Must Primarily Focus on Natural Resources or Real Estate
Master limited partnerships have changed substantially since they were first introduced in the 1980s. People used MLPs as a tax loophole, so the government had to implement legislation to stop them. Due to this legislation, the only types of companies that can enter into master limited partnerships are those in the natural resources, real estate, or commodities industries.
Here are a few prominent MLPs:
- Steel Partners Holdings LP
- Suburban Propane Partners LP
- Genesis Energy LP
- Brookfield Infrastructure Partners LP
- Energy Transfer Operating LP
Investors Can Invest in MLPs Through Stock Exchanges
Since MLPs trade publicly, they’ll work similarly to stocks. You can buy them on national exchanges like the NYSE and NASDAQ. You can also work with popular brokerages. Talk with your financial advisor if you want to add MLPs to your portfolio.
The Tax Implications of MLPs
The tax benefits are big reasons company owners and investors participate in MLPs. Known as flow-through or pass-through entities, MLPs can avoid the dreaded “double taxation” many businesses face. So rather than having both you and your business taxed separately, just the individual business owner is taxed. Simply put, MLPs don’t pay corporate taxes.
This isn’t just good news for business owners but also investors. Since MLPs avoid this tax, the idea is that they should theoretically be able to pass larger dividends to their investors. That said, the business' taxes are passed on (hence the name pass-through entity) to the investors (also known as unitholders).
Since investors are technically partners in the business, their dividends will be taxed as income. Investors receive a K-1 statement that explains their share of the company’s revenue. This will be taxed at each investor’s tax rate.
Pros & Cons of MLPs
MLPs provide a way to earn consistent income through dividends and focus on lucrative industries. That said, they’re not the right option for every investor. Let’s take a look at the pros and cons of MLPs.
- You’ll get substantial tax benefits. Master partners in the partnership get the benefit of avoiding double taxation, as MLPs are pass-through entities that pass on a portion of their taxes to investors. This, however, can lead to more significant returns for investors themselves.
- They’re income-generating. MLPs can only exist within specific industries. Since the real estate and natural resources industries often continue to grow steadily over the years, the dividends you can earn as an investor happen regularly, often quarterly; this provides a steady stream of passive income.
- They’re liquid investments. MLPs are listed on a national exchange, so they’re easier to buy and sell, making them fairly liquid investments. Traditional partnerships, on the other hand, are much more challenging to get out of.
- They’re complicated tax-wise. Although MLPs offer tax benefits for the business, ensuring you meet the standards can be complicated. For example, the company has to ensure that at least 90% of its income comes from natural resources, commodities, or real estate.
- There can be a lack of diversification. While the industries that MLPs exist within — real estate and natural resources — are popular and often profitable, MLPs should not be your sole investment or even a majority of your investments. You must maintain a diverse portfolio if these industries take a hit and perform poorly for an extended period.
- They have a history of legislative challenges. MLPs have already faced legislative headwinds throughout their history, and it’s difficult to determine if they will again. Any change that occurs in the real estate or natural resources world may also have an impact on the MLPs you own. Specifically, the oil and gas industry faces constant changes as the country grows towards more renewable options.
- They’re high-risk investments. Due to a fluctuating legislature and constantly fluctuating prices of commodities like oil and gas, MLPS are anything but safe investment options. They’re meant for more experienced investors who can understand the investing side of the equation and the tax side.
The Bottom Line: Should You Invest in an MLP?
MLPs offer investors and business owners several benefits, but they won’t be suitable for all investors. In general, MLPs could be right for investors who…
- Want to get Into real estate and natural resources. MLPs must be related to either the natural resources industry, the real estate industry, or the commodities industry. Investors who want a way into these industries may wish to consider MLPs.
- Want to avoid “double taxation.” Many business owners face a mountain of taxes come tax season. That’s because business owners face taxation at personal and corporate levels. MLPs are what’s known as pass-through entities, meaning they avoid paying the corporate portion of their taxes. However, for investors, this is a double-edged sword. Pass-through entities are so-called because they pass their taxes onto the investors. Since investors are effectively silent partners in the business, they, too, have to pay income tax on the earnings from their investments.
- Are comfortable taking on risk. While MLPs provide exposure to historically profitable industries, they’re often a more volatile option compared to stocks and bonds. For example, oil, one of the most common MLP industries, is subject to constantly fluctuating prices and legislation that can change the returns you earn as an investor.
Overall, MLPs might be a good investment for those comfortable with risk and who want to get into the real estate or natural resources industry. However, it's essential to remember that these investments can be volatile and complicated from a tax standpoint. As with any investment, it's important to do your research before making any decisions.
Research before you invest in an MLP:
- Asset Classes: Traditional vs Alternative Asset Classes
- Investment Risk 101
- Fossil Fuel Divestment: What It Is & How to Participate