A master limited partnership is a venture that trades like a public company but offers the rich returns and tax breaks of a private investment

• A master limited partnership (MLP) is a publicly traded enterprise that invests in natural resources or real estate.
• Because of their unique tax structure and above-average returns, MLPs are a good source of income.
• MLPs also come along with some risks, including lack of diversification and limited growth potential.

It was the early 1980s. The Sony Walkman had just launched, huge shoulder pads were "in," and master limited partnerships (MLPs), portfolios investing in different ventures or companies, had just been introduced to the financial landscape.

Though publicly traded, like stocks, MLPs were organized like private investments - and as such, were soon widely used to take advantage of a variety of tax loopholes. The IRS caught on, and legislation in 1986 and 1987 seriously curtailed MLPs and how they operated

But MLPs remain popular today, and can still play a role in portfolios - especially for investors interested in certain industries. At its core, an MLP combines the tax benefits of a private partnership arrangement with the liquidity and accessibility of a public company.

Let's take a closer look at what a master limited partnership is, how it works, and the pros and cons to this form of investment.

What is a master limited partnership (MLP)?

A master limited partnership (MLP) is organized as a limited partnership, which is usually a private investment arrangement. However, it trades daily on public stock markets. Investors in MLPs buy units (as shares are called) on a national securities exchange. Investors can see the prices of and sell their units at any time. (Selling units is much harder with private limited partnerships).

MLPs were created to promote investment in some capital-intensive industries, presenting investors with a chance at higher returns and greater diversification than just a single stock. MLPs do offer some growth and chance for profit, but they're most famed for providing substantial income via regular payouts, called distributions. These distributions usually are made quarterly.

The Tax Reform Act of 1986 defined how these companies can be structured and the Revenue Act of 1987 limits what types of companies can ultimately become MLPs. To be considered an MLP today, the venture must focus on acquisitions relating to either real estate, natural resources, or commodities. The majority of MLPs are in the oil and gas industries.

How master limited partnerships work

For the most part, there are two types of partners in an MLP organization: general partners and limited partners.

General partners (GPs) oversee the day-to-day operations of the MLP, maintaining board and management control in exchange for a small ownership stake. Limited partners, or unitholders as they're officially known, are ordinary, outside investors. They provide capital for the MLP's acquisitions and don't have a say in management.

MLPs are known for their steady income streams and rich returns. Many individual MLPs have yields above 10%.

How can they be so high? Because MLPs are bound to distribute 90% of their income to shareholders. They aren't allowed to plow unlimited amounts back into the firm or spend on expansion, as regular companies can do. These returns come either in the form of income generated by the investment properties, or gains from sales of them.

How are MLPs taxed?

But wait, there's more. MLPs have some tax advantages that enhance returns, too.

An MLP is structured as a "pass-through entity." As a "pass-through" entity, the MLP does not pay any income tax itself. So, investors theoretically get more money distributed to them.

Fast fact: Limited partnerships and other pass-through entities get their name because any tax liability "passes-through" them and goes directly to the limited partners.

In contrast, dividends and other payouts from regular companies are double-taxed - the company first pays corporate income tax before distributing them, and then the investor has to pay their own income tax on them.

Then there's the way the quarterly distributions can be classified. Sometimes, it's as income. But distributions can also be classified as a return of capital - which is not taxable when the unitholder receives it. It's only when the investor actually sells their units that any profit would be taxable - and then it's at the capital gains tax rate, which generally lower than the regular income tax rate.

The benefits of investing in MLPs

Like any other investment, there are advantages and disadvantages to investing in master limited partnerships. Among the advantages:

• Tax benefits: Since the MLP is a pass-through entity, it doesn't pay income taxes - which can mean more money for investors. Returns may be taxed as capital gains, too, instead of income.
• High yields: MLPs offer above-average returns. For example, according to a list compiled by Sure Dividend, an investment advisor specializing in MLPs, Alerian MLP ETF (AMLP) yields over 25%, compared to the S&P 500's approximately 2% average dividend yield.
• Dependable returns: MLPs are in industries that have a track record of steady returns, making them fairly reliable investments.

• Liquidity/transparency: MLPs units can be readily sold on a public exchange, and their prices are more transparent than those of a traditional private, limited partnership.

The drawbacks of MLPs

Among the downsides of MLPs:

• Unexpected tax consequences: If you hold your shares in a tax-deferred account, like an IRA, your distributions could be counted as taxable income, requiring you to pay annual taxes on unrelated business income (UBI).
• Lack of diversification: Since these funds limited to certain specific industries - most modern MLPs focus on oil and gas companies - they don't represent a diversified investment. In other words, they are a very specific industry play.
• Low growth potential: Because MLPs redistribute most of their cash to investors, that doesn't leave much money for reinvestment or growth. If not carefully managed, MLPs run the risk of having to take on additional debt to finance operations or deal with expenses.
• Complicated tax filings: MLPs report their distributions on a special tax form called a K-1. These are notorious for being sent out late to investors and can be complicated to decipher. All this makes your tax return filing trickier.

The financial takeaway

Because of their unique structure, master limited partnerships come with some tax benefits that lets them post notably high yields. And they have more transparency and liquidity than traditional partnerships.

However, this unique investment vehicle isn't for everyone. If you are considering going this route, the first step is to do research into the MLP itself.

At base, you should look at how the MLP generates its funds in order to ensure that it has sustainable cash flow. However, you'll also want to look at how much cash that the MLP is carrying in comparison to its distributions. If the MLP violates that rule about distributing 90% of its income, the IRS could disallow its status. And then the partnership, and its unitholders, could face some big tax bills.

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