Master Limited Partnerships (“MLPs”) have been a hot topic in the investment community in the last few years and for good reason.  One of the top performing sectors of the market, MLPs have and continue to play a major role in the developing U.S. energy renaissance.

A MLP is a partnership that provides liquidity because of the ability to trade the partnership interests on stock exchanges.  In order to qualify for MLP status, 90% of a partnerships income must be derived from so called “qualified” income, as that term is defined by the Internal Revenue Service.  This qualification speaks to the line of business that these partnerships are involved in, which for the most part is midstream energy and natural resource infrastructure.  Most of these partnerships have reoccurring cash flow that offers inflation protection and consistent payout to investors.  As the industry continues to grow, MLPs have also started to move to more than just oil and gas pipelines.  Today there are exploration, refining, chemical, fertilizer and real estate companies that are use the MLP structure.

MLPs consist of both limited partners (“LP”) and a general partner (“GP”).  A LP has no say in the management of the MLP, typically provides the capital for the MLP and usually receives periodic distributions from the MLP.  The GP manages the assets owned by the MLP and receives compensation in the form of management fees for the services it renders.

As an investor, or potential investor, in a MLP, it is important to understand the tax implications of buying a MLP.  Most investors buy into a MLP as a LP.  A MLP is treated as a pass-through entity for income tax purposes which means, as a LP, you will be responsible for reporting on your individual tax return your proportionate share of the MLP’s taxable income.  This income is taxed at your marginal income tax rate.  A risk to buying an MLP directly is that you will not create as diversified a portfolio as buying into a fund that owns numerous MLPs.  So to obtain the same diversification as a fund owning numerous MLPs, one must buy many MLPs directly.   If one does this, it will lead to receiving multiple K-1s at tax time which, to some people, can lead to administrative headaches.

For this reason, many investors opt to invest in a portfolio that offers one 1099 rather than multiple K-1s.  One vehicle that offers this type of reporting is a traditional mutual fund.  Most mutual funds qualify as regulated investment companies for tax purposes which allows them to pass on dividends and capital gains without incurring tax at the fund level.  This is not the case with MLPS if the MLP exposure is greater than 25% of the total fund assets.  In this case, the fund is taxed as a C-Corporation which means the income derived inside of the fund will be taxed at the fund level.  This tax creates a drag on the net asset value of the fund which can lead to underperformance versus a direct MLP investment.

Another vehicle to consider that avoids taxation at the fund level is an Exchange Traded Note (“ETN”), which is an unsecured debt obligation issued by a bank that tracks the performance of an index or basket of securities.  With an ETN, cash distributions to individual investors are taxed at ordinary income rates, but there is no taxation at the fund level.  From a performance perspective, it can be very beneficial to own an MLP ETN in a tax-deferred account.  An ETN, however, is a passive strategy – this means that you don’t own the MLP directly and there could be some credit risk involved with the issuer.

In conclusion, as there is some complexity to the tax structure of MLPs, it is important to understand how the type of MLP you purchase affects your tax liability and investment performance.  There is no perfectly structured vehicle to invest in MLPs from a tax standpoint.   Each vehicle or fund has is its own advantages and disadvantages and it is important that you understand what those are.  That being said, the growth of the industry and the impact it is having on our economy is very exciting and the opportunity to benefit from this growth is worth considering.