An Investor's Guide to Master Limited Partnerships

Investors who search for high-yielding investments have more than likely stumbled upon a master limited partnership, or MLP. These types of investments can be a great addition to a portfolio. For instance, the Alerian MLP index, a market cap-weighted index of the 50 largest MLPs, has an average yield of 6.02%.

But here's the catch: MLPs aren't your average corporation. (In fact, they aren't even corporations at all, at least according to the IRS.) Let's take a closer look at these types of investments and see what they might mean for your portfolio.

The basics
Just as with owning stock in a company, as a unitholder (the fancy word this space uses for a shareholder) in an MLP, you are a part-owner in the business. What sets the two apart, though, is that the partnership passes all tax obligations to you, the investor. To be an MLP, a company needs to derive 90% of its resources from certain types of activities. Here are a few examples.

• Linn Energy (LINEQ), an oil and gas exploration and production company, is granted MLP status because it derives all of its revenue from the production of natural resources and hedges the price of the commodities through futures trading. As long as the company only produces natural resources, it can maintain its MLP structure.
• Coal and timber also qualify as natural resources under MLP regulations. So even though a more diversified company such as Brookfield Infrastructure Partners (BIP -1.33%) has multiple revenue sources, they are MLP-eligible because more than 90% of that revenue qualifies under MLP regulations.
• The only non-natural-resource income that qualifies for MLP status is interest, dividends, capital gains, and rental income from real estate. So a holding company such as AllianceBerstein Holdings (AB 0.57%), most of whose income comes from owning assets, can also be eligible for MLP status 

Much of the MLP space is dominated by entities specializing in natural resource activity, most notably midstream oil and gas operations. As part of the rules defining a MLP, these entities are required to pay out to its unitholders all of its distributable cash flow not needed for current operations and maintenance of assets. Since the distribution is based on cash flow and not earnings, you will see very high payout ratios for MLPs. That can be very misleading, though. Let's look at the five largest MLPs by market cap to see why.

Sources: Morningstar, Yahoo! Finance, and author's calculations.

Here we have two great examples of why to double-check payout ratios for MLPs. At first glance, a 200%-plus payout ratio for Kinder Morgan seems unsustainable, but its payout ratio based on cash flow is much healthier at 76%. On the other hand, we have Energy Transfer Partners and its seemingly healthy 90% payout ratio. If you look at its cash flow payout, you see that it's more than total operational cash for the past 12 months. Since income statements have non-cash considerations such as depreciation and amortization, it can skew payout ratios. Be sure to look at payout ratios based on cash flow rather than income when investing in MLPs.

The taxes
One of the big hitches with owning part of an MLP is the taxes. Partnerships are considered a pass-through entity. That means that you, the investor, are responsible for paying the taxes on your share of the company's income. You get all the benefits of income taxation (such as deductions and credits), but all the paperwork headaches as well. The partnership helps you pay these taxes through its distributions. To file taxes on an MLP, the company will send you a K-1 form that details your tax obligations for the company.

But keep in mind that distributions do not equal income. So it is possible that the distributions you receive will exceed your portion of net income for the year. Excess distributions are considered a return of capital, and you are not taxed on them until you sell your shares in the partnership.

To give a clearer picture of how this works, let's do a quick run-through of an end-of-year scenario with a single share/unit for both a corporation and a MLP. Since an MLP makes its distributions based on distributable cash flow and not income, the distribution does not include depreciation or amortization. The unitholder then pays the marginal tax rate for his or her share of income and pockets the rest. Conversely, a corporation pays 35% on its net income. It then passes on a set amount of that post-tax income to its shareholders in the form of a dividend, which is taxed again at the capital gains tax (15% to 20% based on your income bracket).  

Since you are responsible for the corporate taxes, this also means that if the company posts an income loss for the year, you are allowed to carry that loss over toward next year's taxes. What makes losses on MLPs unique, though, is that you can only carry that loss over to that individual investment and not your entire portfolio.

Whenever a cash distribution exceeds an investor's share of income, it is considered a return of capital. These returns are considered a payback on what you originally paid for the company, and reduce the basis of your original investment. When you sell out of your position in the company, you will realize these gains on top of any gain from the appreciation of the stock price. So let's say you pay $100 for a unit of an MLP and later you receive $10 in returned capital from distributions. At this point your cost basis would be reduced to $90. Also, let's say after a specific period your capital gains appreciate by $20. When you decide to sell the unit, the cost basis increases to $110, so the total gain from the investment is the sell price minus your reduced basis, which in this case is $20.

Also, the taxes on that realized gain are slightly different. Throughout the life of the investment, you have deducted depreciation costs from the income taxes, and you will need to pay the corporate tax rate on that portion of your gain. The remaining part of the profit is then taxed at the capital gains rate.

What a Fool believes
While the paperwork involved in an MLP is more complicated than with a traditional company, the benefits could be well worth the headache. Keep in mind that the examples above are a simplified case. So unless you are an accounting wizard, I would certainly talk to a tax professional about MLP tax structure before venturing out on your own.

The combination of high-yielding distributions and preferential tax treatment make MLPs a good investment for income investors and anyone looking for yield. Because of that tax treatment, though, investors who are looking into an MLP should look to hold for the long term. MLP status could help shape your investment thesis for a company, but in no way should it be the only factor you look at. Keep in mind that you are buying a company, and you should do your due diligence on that company before becoming an owner.  

Editor's note: A previous version of this article mistakenly claimed that MLP unitholders are taxed at a corporate tax rate of 35%. In fact, they are taxed a personal marginal tax rate. The Motley Fool regrets the error.