What You Should Know About This Popular Income Investment

Nov 04, 2022

I love hearing from Money Talks readers. And in the last several months, I’ve received more questions on one topic than just about any other.

I’m talking about income investing.

It’s not surprising… With inflation steadily eating away at our purchasing power and an ongoing bear market in many assets, it’s never been more important to find sources of safe, steady returns.

Recently, several folks have asked about one type of income investment in particular: master limited partnerships, or “MLPs.” So today, I’d like to review the basics you need to know before considering an investment. 

What are MLPs? 

If you’re not familiar, a limited partnership (LP) is a type of business organization meant to limit the personal liability of some partners. 

An LP generally consists of at least two partners. It has one or more “general partners” who oversee the business and are responsible for its debts. And it has one or more “limited partners” — i.e., investors — who don’t participate in managing the business and are only liable up to the amount of their investment. 

LPs are also known as “pass-through entities,” meaning they’re generally not required to pay corporate income taxes. This benefit means they’re able to distribute — or “pass through” — more of the cash they earn to investors than a typical corporation. An MLP is simply a type of LP traded publicly on a stock market exchange. That makes MLPs a relatively unique type of investment that combines the tax benefits of a private LP with the greater liquidity of a publicly traded stock.

To receive these tax benefits, MLPs must generate at least 90% of their income from “qualifying sources,” which are generally limited to real estate- and natural resources-related businesses. But most MLPs are focused on the energy sector, and the oil and gas “midstream” industry in particular. 

This focus means most MLPs employ a “toll road” business model, where they receive a fee to facilitate the transportation and processing of oil, natural gas, and refined energy products.

Benefits of Investing in MLPs

MLPs offer several potential benefits for investors. As you can probably guess, one of the biggest has to do with taxation. 

MLP investors (or “unit holders” as they’re officially known) are only taxed when they receive distributions. However, in practice, because of how distributions are paid (from the partnership’s cash flow rather than net income), distributions are often tax-deferred until the MLP is sold. 

This benefit can also make MLPs an especially good vehicle for estate planning. 

And again, because MLPs are pass-through entities, they aren’t required to pay corporate taxes. That means their distributions to investors aren’t subject to double taxation like ordinary stock dividends when the bill finally comes due. 

This favorable tax structure also leads to another benefit of MLPs: attractive, inflation-beating yields. 

With more cash available to distribute to investors, MLPs also tend to offer significantly higher yields than you’ll find in most bonds and dividend-paying stocks. And because they typically operate stable, “boring” businesses in energy-related industries, these yields tend to remain relatively steady while keeping up with inflation over time. 

Finally, as I mentioned, MLPs are generally as easy to buy and sell as any other blue-chip stock you might own. That means you can take advantage of these benefits without worrying about potential liquidity concerns like you would if you invested in a private LP. 

Risks of Investing in MLPs

However, there also are some potential drawbacks of MLPs that you need to be aware of. And ironically, one of the biggest is related to taxes as well. 

You see, while MLPs can offer some great tax benefits, those benefits can come at a cost. Specifically, their unique structure requires different — and often more complicated — tax reporting. 

Rather than the usual investment-related tax forms, investors are issued a “Schedule K-1” document, which details each investor’s share of the MLP’s net income. Investors are then required to pay taxes on this net income — rather than any distributions received — at their own income tax rate. 

These differences can create some unexpected headaches when tax-filing season comes around. 

In addition, for some reason, Schedule K-1s are often not mailed out to investors until mid-March or later, which can also delay tax preparation and filing. 

However, investors can partially mitigate this by downloading these forms electronically rather than waiting for them to arrive by mail. They are typically available for download on the individual MLP’s website or via a centralized resource like Tax Package Support.

Because of their structure, MLPs can also generate what’s known as “unrelated business taxable income” (UBTI). Under certain circumstances, UBTI can be subject to income taxes even in tax-exempt or tax-deferred retirement accounts. That means MLPs are generally not a great investment for IRAs or 401(k)s. 

The second potential risk of MLPs is price volatility. 

While the income they generate tends to be relatively stable, that isn’t necessarily the case for their share (or “unit”) prices. MLPs have historically experienced higher price volatility than bonds and many traditional dividend-paying stocks. 

For example, the Alerian MLP ETF (AMLP) — which tracks the Alerian MLP Infrastructure Index — currently has a TradeSmith Volatility Quotient (VQ) of 27.60%. That compares to VQs of 7.69% in the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) and 17.55% in the S&P 500 Index (SPX).

MLPs are also typically reliant on debt and equity markets to raise capital, so their price volatility can be even greater during periods of market turmoil. (That said, MLP prices tend to be highly correlated with the price of oil and gas. So, if you believe energy prices are likely to do well, this may be a lesser concern.) 

Next, while MLP distributions are generally more stable than their unit prices, they can also be impacted by commodity prices. Namely, if energy prices were to fall significantly for a prolonged period, the sustainability of many MLP distributions could come into question. 

Finally, MLPs can carry regulatory and political risks, as well. These can be related to commodities — such as permitting issues or new energy policies — or changes in the tax code. 

The Bottom Line 

As you can see, MLPs offer some unique advantages you can’t find in most other income investments. And they could do particularly well if energy inflation continues to persist as it has this year. 

However, because MLPs can also create some complicated tax consequences, I recommend checking with an accountant or tax adviser before you consider adding them to your income portfolio today. 

As always, if you have any questions or comments on today’s editorial — or any previous Money Talks topics — you can reach me directly at [email protected]. I can’t respond to every email, but I read them all.