Dividend-paying stocks are an excellent tool for investors to not only earn income but also outperform the market. That's because the best dividend stocks have historically outpaced the S&P 500 by a wide margin. However, one issue many investors have with them is how the government taxes dividends. Not only do corporations pay taxes on their earnings before they pay dividends, but investors also often pay an additional tax on this income at the individual level. This double taxation eats into an investor's return.

One way investors can avoid this double taxation is by investing in master limited partnerships (MLPs), which are entities that have chosen to structure as partnerships for tax purposes. Because of that, they don't pay any corporate income taxes. Instead, the partnership's income passes through so that it's only taxed once, at the level of the individual partner. That tax rate tends to be lower than the corporate one. Furthermore, since MLPs also pass through deductions like depreciation, taxes are often deferred. This structure enables investors to avoid double taxation and keep more of the profit.

These are just some of the factors that differentiate MLPs from other investments. This guide will help investors better understand MLPs so that they can determine whether these tax-advantaged entities are right for their portfolios.

People making calculations with a stock chart in the foreground.

Image source: Getty Images.

How were MLPs created?

Oil and gas producer Apache (NYSE:APA) formed the first MLP in 1981. In doing so, it offered investors the tax advantages of a partnership with the liquidity of publicly traded securities like stocks and bonds. Apache's initial success with the MLP model caused many other oil and gas companies to adopt the structure. In addition to that, companies in different industries such as real estate, hospitality, and entertainment also converted into MLPs.

Congress, however, moved to limit the types of businesses that could become MLPs when it passed the Tax Reform Act of 1986 and the Revenue Act of 1987. These laws determined that an MLP must earn at least 90% of its gross income from qualifying sources, which at the time included the transportation, processing, storage, and production of natural resources and minerals. The IRS has since broadened the activities that generate qualifying income to include some related to the finance industry.

As partnerships, MLPs have two layers of ownership: general partners (GPs) and limited partners (LPs). The GP is the controlling body, while the LPs contribute funds and participate in the economic gains and losses of the MLP. Many LPs pay management fees to their GP, which can be separate publicly traded or privately held entities or owned directly by the LPs.

Types of MLPs

Because of the qualifying income limitations, MLPs operate in the following sectors:

Energy

Most activities relating to the production, transportation, processing, and storage of energy and natural resources qualify for being included in an MLP. Because of that, investors will find MLPs involved in the following energy- and natural resource-related activities:

  • Upstream oil and gas exploration and production as well as owning mineral and royalty interests
  • Midstream activities such as the gathering, processing, compression, and storage of oil and gas
  • Marine midstream transportation, including operating gas carriers, oil tankers, and floating, production, storage, and offloading vessels
  • Oilfield services such as drilling services and fluids handling
  • Downstream activities such as refining, marketing, and wholesale distribution
  • Propane distribution
  • Coal mining
  • Other natural resources such as biomass, timber, sand, and renewable energy

Financial

Certain financial activities also produce qualifying income for MLPs. These include:

  • Investment and finance, such as a private equity partnership or other investment entity
  • Commercial real estate partnerships

Other

A small handful of nonenergy and nonfinancial MLPs exist, some of which were grandfathered in during the 1980s. For example, amusement park operator Cedar Fair is an MLP.

While MLPs span energy, finance, and other sectors, 80% of the MLP market engaged in activities related to energy and natural resources -- with 90% of those MLPs focused on oil and gas midstream -- as of the middle of 2019.

Key terms for MLP investors

MLPs are quite different from traditional corporations, so investors need to learn several terms and metrics used by these entities.

Partnership units

Corporations issue shares of stock to their investors, which are also known as shareholders. MLPs, on the other hand, issue units to their partners, which makes them unitholders.

Distributable cash flow (DCF)

This metric details the amount of cash flow an MLP produces in a period that it could distribute to its partners, making it similar to free cash flow.

Distributions

Corporations pay dividends to investors in their common stock. MLPs, on the other hand, pay cash distributions to their partners.

Incentive distribution rights (IDRs)

IDRs are cash payments that LPs make to their GPs, similar to a management fee. These fees, which typically rise with the distribution, incentivize the GP to grow the partnership. However, IDRs have become a significant burden to many MLPs, since they can entitle the GP to a large percentage of the LPs' cash flow. This weight led many LPs to eliminate their IDRs in the last decade by either acquiring their GPs or buying out their IDRs.

Distribution coverage ratio

This metric measures how many times an MLP can cover its distribution with cash flow. As such, it's the inverse of a dividend payout ratio, which measures the percentage of a corporation's cash flow that it pays out to investors.

Earnings before interest, taxes, depreciation, and amortization (EBITDA)

EBITDA, like DCF, is a common non-GAAP metric used by MLPs to show investors a better approximation of its underlying earnings and cash flow. They use these measures because traditional ones like net income don't show their full earnings power. That's because they record large depreciation charges against their assets, which reduces their taxable earnings.

The word TAXES spelled out on wooden blocks with money underneath.

Image source: Getty Images.

MLPs and taxes

One of the advantages of investing in MLPs is that these pass-through entities enable investors to avoid the double taxation of dividends. In addition to the income, MLPs also pass on their deductions, which reduces the partner's tax liability. Therefore, individual investors pay taxes on the income not only just once but also on the lower amount after deductions, enabling them to keep more money.

However, while the higher net retained cash after taxes is one of the positives of investing in MLPs, investors do need to be aware of some of the negatives of investing in these entities. First, instead of a 1099-DIV Tax Form, MLPs send their partners a Schedule K-1 Form so that they can file their income taxes. This form provides investors not only with their share of the partnership's income but also with gains, losses, deductions, and credits so that they can accurately file their taxes. One of the issues with these forms is that they take longer to prepare. As a result, MLPs aren't able to make them available in January when most 1099s arrive. While they usually can provide them before the individual tax filing deadline in mid-April, this delay means MLP investors can't file their taxes until much later in the season.

Another negative when investing in an MLP is that certain tax issues can arise if an investor holds one in a tax-exempt retirement account like an IRA or 401(k). Doing so could cause an investor to be subject to Unrelated Business Taxable Income (UBTI), which is a tax levied on tax-exempt organizations on income that's not related to their purpose. In the case of MLPs, the retirement account becomes the LP. However, because the MLP's business is unrelated to the retirement account's tax-exempt purpose, this income gets taxed.

Investors can get around the tax issues associated with MLPs by investing in either a taxable corporation, mutual fund, or exchange-traded fund (ETF) that owns MLPs. For example, the GP of oil pipeline MLP Plains All American Pipeline (NYSE:PAA), Plains GP Holdings (NYSE:PAGP), is a publicly traded entity that owns units of Plains All American and issues a 1099 form for tax purposes. Thanks to that, investors in Plains GP Holdings benefit from the same economic interest in Plains All American Pipeline's assets without the tax headaches of the Schedule K-1. That allows them to hold shares of Plains GP Holdings in a tax-exempt account.

Another option is to invest in a fund that holds multiple MLPs. The Alerian MLP ETF, for example, invested in nearly 25 MLPs in the middle of 2019, giving investors broad exposure to the sector. On top of that, it issued a 1099 form to its investors for tax purposes, which made it eligible for both IRAs and 401(k)s.

The headwinds facing MLPs

MLPs have gone in and out of favor with investors over the years. A combination of lower interest rates and high oil prices caused investors to flock to these high-yielding vehicles following the financial crisis of 2008 through the oil price crash of 2014. That slump in crude prices, however, hit MLPs hard. Most of the ones focused on upstream production went bankrupt due to the amount of debt they piled on to expand. Financially weaker midstream MLPs also struggled because of the fallout of the oil price crash. Many had to reduce their cash distributions and use that money to pay down debt and finance expansion projects. While most MLPs have taken steps since the oil market downturn to further limit their direct exposure to oil prices, this volatility remains a headwind for the sector.

MLPs also face headwinds from the government. The Tax Cuts and Jobs Act of 2017, for example, reduced the corporate tax rate from 35% to 21%, which cut into the tax advantage of MLPs. Meanwhile, in 2018, the Federal Energy Regulatory Commission (FERC) ruled that MLPs couldn't recover an income tax allowance as part of the fees they charged to shippers on interstate pipelines. That decision negatively impacted the cash flows of several MLPs that operated these long-haul systems. Those two changes led many MLPs to convert into corporations in 2018 and 2019. Future changes to the tax code could further erode the advantages of MLPs, while additional regulatory policy shifts could make them less appealing entities for the energy sector.

Finally, changes in interest rates have a notable impact on MLPs. When they rise, it's more costly for these heavily indebted entities to borrow money, which can impact their cash flow. On top of that, rising rates cause the yields of lower-risk investments like bank CDs and bonds to rise, which makes them more attractive to income-focused investors. That cuts into the appeal of MLPs, which are riskier than those alternatives.

A burst of sunlight shining on a pipeline.

Image source: Getty Images.

Tailwinds that could positively impact MLPs

While the oil market's prolonged downturn from 2014 through 2016 -- and slow recovery in the years following the crash -- hurt MLPs, these entities have emerged much stronger. Many went to great lengths to improve their financial profiles, including selling assets to shore up their balance sheets and reducing their distributions to boost their coverage ratio. As a result, many MLPs now have higher credit ratings, which will reduce their borrowing costs. Also, many have increased their distribution coverage ratios to much more comfortable levels (1.2+ times in most cases). These factors will make MLPs less reliant on issuing new units and debt to fund growth, which will lower their risk profile.

MLPs have improved their overall value proposition to investors since the oil market downturn. These entities used to be entirely distribution driven. As a result, the only return an investor typically earned was on the income received, which MLPs aimed to increase each year. However, they have since pivoted to a total return model. This new approach should enable investors to earn income while also benefiting from capital appreciation as they grow the value of the partnership.

For example, Enterprise Products Partners (NYSE:EPD) slowed its distribution growth rate in 2018 so that it could retain more cash flow. The MLP intended to use most of this money to invest in high-return expansion projects that would grow DCF. However, in 2019, Enterprise Products authorized a $2 billion unit repurchase program to help reduce its unit count, which should increase the units' value.

MLP opportunities that investors won't want to overlook

While most investors buy MLPs to collect their above-average income streams, the midstream sector, where most of these entities focus, has significant growth potential. That's because North American energy companies need to invest about $800 billion, or roughly $44 billion per year, in building new midstream infrastructure through at least 2035 to support the continent's anticipated production growth, according to a study by the INGAA Foundation. This large opportunity set should enable MLPs to expand their operations and grow their cash flows, which should support higher distribution levels.

Another opportunity in the MLP segment is consolidation, both internal and external. Several energy companies consolidated their MLPs in 2018 following the changes in both the tax code and the new FERC ruling on pipeline taxes. That trend could continue for several years, with one estimate suggesting that MLPs need $50 billion of capital through 2021 to complete structural simplification transactions, including completing deals that eliminate the IDRs paid to their general partners. Meanwhile, MLPs could also benefit from merging to create larger, more diversified entities, which would reduce their costs and improve scale. These consolidation moves should also improve returns, which could boost valuations in the sector.

The risks of investing in MLPs

Because the majority of MLPs operate in the energy sector, oil price volatility is a major risk facing these entities. While most MLPs operate assets backed by long-term fee-based contracts, many do have some direct exposure to commodity prices. When those prices decline, it puts some pressure on MLP cash flows.

Another risk facing MLPs is increasing concerns surrounding climate change. These worries are causing more opposition to new pipeline projects. That's delaying and driving up the costs for projects, which is impacting investment returns for MLPs. If climate change concerns continue to worsen, it could negatively impact the long-term growth potential of the midstream sector, which would hit MLPs hard.

MLPs shifted their funding models following the oil market downturn so that they're now retaining a larger percentage of their distributable cash flow to help finance growth. However, they still need to have the flexibility to sell new units to fund expansions and acquisitions. The issue is that the market for MLP equity tends to ebb and flow with investor sentiment, which can change with things like oil prices and interest rates. Because of that, MLPs aren't able to access funding as easily as corporations, which could impact their ability to create value for unitholders.

MLPs can be an excellent option for certain investors

MLPs aren't for everyone. Since they're already tax-advantaged entities, they aren't suitable for retirement accounts. So investors need to be comfortable not only with owning them in a taxable account but also with the associated extra paperwork required at tax time.

MLPs, however, can be great options for investors who want to earn an above-average income stream and are willing to deal with those tax issues. Many also have appealing upside potential, especially those in the midstream sector, given the investments needed to expand North America's energy infrastructure. That combination of growth and income could enable many MLPs to produce market-beating total returns in the coming years.