Master limited partnerships, or MLPs, are a popular niche investment for folks seeking to profit off America’s energy and mining industries. Most MLPs today engage in oil and natural-gas production, deriving most of their cash from the processing plants and pipelines they own.

Like stocks and bonds, MLPs pay dividends and can be bought and sold on regular stock exchanges. But what makes MLPs unique (and unstocklike) is that they offer investors benefits that they can’t find in other investments.

These include exclusive tax advantages, reliable cash flows, limited liability for protection against the MLPs’ debts, capital appreciation, and higher-than-average dividend yields.

MLPs also have a complex structure, especially when it comes to taxes. They’re better suited for more sophisticated investors and those who’ve done their homework.

So What Is a Master Limited Partnership, Exactly?

Master limited partnerships have been around for over 40 years. They arose in 1981 after Congress started to allow publicly traded, tax-exempt partnerships to help spur investment in troubled industries like oil drilling and production.

The simple reason is that it’s expensive to run drilling wells and other facilities to process the oil and ship the final product to hundreds of markets.

Not being burdened with taxes is a powerful incentive to launch an MLP, which must derive at least 90 percent of its income from holdings and operations in real estate, natural resources, or commodities.

Today, investors have access to more than 100 MLPs, with a majority focused on gathering and processing oil and natural gas — compression, storage, and transport operations. Other MLPs pump the oil and gas out of the ground and refine it. Yet others are miners who go after coal, fertilizers, and minerals.

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How Does an MLP Work?

To understand how MLPs work, you must understand their complicated structure. First and foremost, the federal government treats them and other publicly traded partnerships as tax-exempt companies. This special tax treatment is key because MLPs can use those savings to pursue projects that might not otherwise be economically feasible for a taxable entity such as a corporation.

Since MLPs don’t pay any income taxes, they instead pay out their cash flow in the form of cash distributions (like dividends that corporations pay stockholders) to investors, who are called unitholders because they buy units of the partnership.

Unitholders are limited partners (LPs) in the MLP. They must pay federal, state, and local taxes on their share of the MPL’s income, gains, loses, and deductions. However, unitholders don’t pay taxes on the cash distributions they receive.

Without these special tax advantages, MLPs wouldn’t exist, and many energy companies and projects would never have been launched.

MLPs tax-free status makes them “pass-through” entities, as they pass on their income tax liability to unitholders.

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The Importance of General Partners

There’s another class of MLP owner: the general partner (GP). This is the person responsible for managing the day-to-day operations of the partnership. The general partner typically has a 2 percent stake in the partnership, which is privately purchased. However, GPs can increase their ownership stake in the MLP by buying limited partnership units.

In most cases, GPs are paid on a sliding scale called incentive distributions rights. Under this system, GPs get an increasing share of the cash distributions as the level of those distributions to unitholders (or LPs) rise and meet certain thresholds. The theory is the sliding scale-payment system compels GPs to increase cash distributions to unitholders.

The Benefits of MLPs

The biggest lure for MLP investors is yield. Most pay around 7 to 8 percent annually. Plus, industries within the MLP universe are typically stable and reliable players. They can produce a consistent and steady cash flow year after year, making cash distribution from MLP units predictable. This helps investors better plan their portfolio strategies.

Another appeal is that MLPs don’t take on exposure to commodity prices. That helps reduce investment risk and cash-flow volatility.

But there’s another benefit — one perhaps even better than yield: When comparing stock dividends to the MLP cash distributions, MLPs win, hands down.

Stock dividends come out of a corporation’s after-tax earnings. That means stockholders get taxed twice, given that they must pay tax on the dividend. However, MLPs avoid this double-taxation trap because unitholders only pay a single tax on the MLPs’ net earnings.

Furthermore, the cash distributions unitholders receive are tax-deferred year after year. When sell-time comes, investors only pay capital-gains taxes, which are lower than standard income-tax rates.

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The Drawbacks

MLPs are complex and legal corporation structures. Read their annual reports. If the MLP can’t easily explain its purpose, move on.

Keep in mind that MLPs can have ownership interests in outside companies that own partnership interests in the MLP itself. Talk about a conflicts.

Plus, those incentive distributions rights that GPs enjoy come at the expense of LPs over time. GPs take more from the cash-flow stream, and they can issue more shares to grow cash flow. What happens as a result? LPs get smaller cash distributions.

Another problem with the GP-LP divide is that LPs don’t have voting rights (while stockholders do). That arrangement affords GPs a lot of authority over operations and other aspects of MLPs.

MLPs also suffer from a limited pool of investors, making them riskier. Big investors like pension funds won’t touch MLPs due to liability concerns.

The last criticism is political. Some folks are genuinely troubled that MLPs, which are basically corporations, are designed to avoid paying income taxes and to give their investors special tax advantages, as well.

How to Invest in MLPs

You can purchase MLPs through a brokerage just like you would with stocks, bonds, mutual funds, or exchange-traded funds (ETFs). Remember, you’ll pay a small commission each time you buy or sell.

Most MLPs are paying an average yield between 7 and 8 percent, which is much higher than bonds across the board for 2020.

Master limited partnerships can make a great addition to a well-diversified portfolio. Just remember that MLP investing is for folks who know what they’re doing. So do your homework if interested.