One investment vehicle that any investor interested in income should be familiar with is the master limited partnership, or MLP, as they are some of the best income investments available today. Most master limited partnerships are in the business of owning and operating oil and gas pipelines such as Kinder Morgan Energy Partners (NYSE:KMP) or Enbridge Energy Partners (NYSE:EEP). However, there are some MLPs that actually operate oil and gas wells such as Breitburn Energy Partners (NASDAQ:BBEP) and Mid-Con Energy Partners (NASDAQ:MCEP). In this article, we will discuss how these investments work and why they deserve a place in your income portfolio.

What is an MLP?
A master limited partnership is not a corporation, but is instead a partnership that trades publicly on a stock exchange such as the NYSE or NASDAQ. Similarly to private partnerships, an MLP is a passthrough entity; this means that no taxes are levied on the business itself. Instead, all of the partnership's income is considered to be the personal income of the partners. Unlike a private partnership, however, an MLP has to pay out at least 90% of its net income to its partners in order to avoid being taxed on the business level. In order to represent each partner's stake in the business, the partnership's interests are divided up into units, and these trade publicly on exchanges just like stocks.

All of this sounds rather complicated, but it's really not so bad. Basically, you buy the partnership's units through your broker just like you would any other stock. You then collect the distributions when the company pays out its earnings to everyone that owns its partnership units.

High yields
Master limited partnerships are much like real estate investments trusts in that they have to pay out at least 90% of their earnings in order to avoid being taxed on the business level. Because of this, MLPs tend to have relatively high yields. For example, Breitburn Energy Partners currently yields 9.78% and Kinder Morgan currently yields 7.21%.

Tax benefits
Another advantage of master limited partnerships is that some of the distributions that they pay are completely tax free. This is because of their status as pass-through entities. MLPs not only pass through their income but they also pass through their depreciation or depletion write-offs.

Basically, by investing in an MLP, you receive your proportionate share of the partnership's income and you also receive your proportionate share of its depreciation expenses. Because of this, you are able to reduce the distributions that you receive by the amount of this depreciation expense that is assessed to you. Of course, you don't really have to pay this depreciation expense to anyone. Therefore, it's just a way to receive some of the money that the company sends you tax-free.

Frequent dilution
Unfortunately, the fact that MLPs have to pay out nearly all of their earnings also has a downside. It makes it very difficult to expand. To overcome this problem, many master limited partnerships create and sell new partnership units frequently to raise the money that they need to expand. Doing this results in a growing unit count and the frequent dilution of existing unitholders. As an example, this chart shows the number of partnership units outstanding that Breitburn Energy Partners had at the end of each quarter over the past year:

Quarter Ending December 31, 2013 September 30, 2013 June 30, 2013 March 31, 2013 December 31, 2012
Common Units Outstanding 119,170,000 99,680,000 99,680,000 99,680,000 84,668,000

Source: Breitburn Energy Quarterly SEC Filings

As the chart shows, Breitburn has had to steadily increase its unit count over the past year in order to raise the money that it needed to expand its operations.

However, this constant unitholder dilution may not be a bad thing if the money that is raised is used for things that will grow the partnership's cash flow enough that the partnership can consistently grow its per-unit distributions. This was the case with Breitburn, which has steadily increased its distribution over the past year.

Quarter Q4 2013 Q3 2013 Q2 2013 Q2 2013 Q1 2013
Distribution per Unit $0.4926 $0.4875 $0.4800 $0.4750 $0.4700

Source: Breitburn Energy

Please note that Breitburn began paying monthly distributions this year. Therefore, the first quarter distribution listed in the chart above is the sum of Breitburn's first three monthly distributions of 2014.

In conclusion, master limited partnerships are a somewhat unusual investment, but they can and should be very appealing for income focused investors.

Daniel Gibbs has no position in any stocks mentioned. His research firm, Powerhedge LLC, has a business relationship with a registered investment advisor whose clients may have positions in any of the stocks mentioned. Powerhedge LLC has no position in any stocks mentioned and is not a registered investment advisor. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.