Master Limited Partnership (MLP)

A master limited partnership is a limited partnership whose ownership units are listed and traded on a public exchange, so an investor buys and sells them through an ordinary brokerage account while remaining a partner rather than a shareholder. The SEC describes MLPs as "exchange-traded investments that are focused on exploration, development, mining, processing, or transportation of minerals or natural resources", holding cash-generating assets such as oil and gas properties or pipelines. The label is a market convention: the Internal Revenue Code regulates the same thing under the name "publicly traded partnership", and an MLP is simply a publicly traded partnership that has qualified to keep partnership tax treatment.

The statute's default is corporate treatment, and that is the fact everything else follows from. Section 7704(a) says that a publicly traded partnership "shall be treated as a corporation", except as provided in subsection (c). Section 7704(b) defines a publicly traded partnership as one whose interests are traded on an established securities market or readily tradable on a secondary market or its substantial equivalent. Section 7704(c) then supplies the escape: the corporate treatment does not apply for a taxable year if "90 percent or more of the gross income of such partnership for such taxable year consists of qualifying income", and the test must have been met in every preceding year the partnership has been publicly traded since 1987. So the sentence "an MLP does not pay corporate tax because it is a partnership" is backwards. It avoids corporate tax because it passes an income test, every single year.

What counts as qualifying income explains the sector map. Section 7704(d) lists interest, dividends, real property rents, gain from selling real property, and income and gains from the exploration, development, mining, production, processing, refining, transportation, and marketing of any mineral or natural resource, among other categories. Pipelines and energy storage fit that list cleanly and ordinary operating businesses do not, which is why the SEC's own bulletin notes that "most MLPs are currently in the energy sector, particularly in the pipeline or energy storage industries" and warns that they "can be acutely sensitive to shifts in oil and gas prices".

The K-1 is the practical difference an investor actually feels. A partner is taxed on their allocated share of the partnership's income whether or not cash was distributed. The SEC states this bluntly: limited partners "report on their tax returns their share of the MLP's income, gains, losses, and deductions, and are taxed at their individual tax rates", each receives a Schedule K-1, and "investors may need to file state tax returns in states where the MLP operates even though the investors do not live in that state". The bulletin adds the uncomfortable corollary that MLP investors "must pay applicable federal, state, and local income taxes even if the MLP does not provide the investor with cash distributions", giving debt discharged in a restructuring as an example. K-1s also arrive later than 1099s, because the partnership has to complete its own return before it can tell each partner what to report.

Distributions, basis, and the bill that arrives at the end. A cash distribution from a partnership is not itself taxable income. Section 731(a)(1) recognizes gain only to the extent money distributed exceeds the partner's adjusted basis, and Section 705(a) increases basis by allocated income and decreases it by distributions. Where the income allocated on the K-1 is smaller than the cash received, the difference reduces basis rather than being taxed now, and a lower basis means a larger gain whenever the units are sold. Part of that eventual gain may not be capital gain at all: Section 751(a) treats the portion of the sale proceeds attributable to unrealized receivables as amounts realized from property other than a capital asset, and Section 751(c) folds depreciation-recapture amounts on the partnership's own property into that definition. Sponsors compute this and supply a supplemental sale schedule with the final K-1.

The governance features are their own risk, and the SEC says so. An MLP is controlled by a sponsor through the general partner, and the MLP has no board of its own. Most listed companies must have a majority of independent directors, but the bulletin notes the general partner "is only required to have independent directors on its audit committee", and that MLPs "can opt for a lower standard of care ... than the more stringent fiduciary standard generally owed to shareholders of corporations under state law". The sponsor also typically holds incentive distribution rights entitling it to a rising share of payouts as distributions cross thresholds, which the bulletin flags as a reason a sponsor may push the MLP to sustain distributions "even if it requires borrowing by the MLP or refraining from making capital expenditures".

Holding one inside a retirement account raises a separate problem. A partnership's business income allocated to a tax-exempt account can be unrelated business taxable income, which is why the tax-free-growth page treats an IRA holding a publicly traded partnership as its worked example of the exception to a Roth's usual freedom from tax. That is a live consideration before putting an MLP in an IRA, and it is explained there rather than here.

A sponsor, often a public company, contributes assets such as pipelines to a partnership and sells limited partner units to the public. The sponsor keeps control through the general partner and typically holds incentive distribution rights. Each quarter the partnership distributes cash. Each year it allocates income, gains, losses, and deductions to unitholders on Schedule K-1, and each year it must clear the 90 percent qualifying-income test to remain taxed as a partnership rather than as a corporation.

A hypothetical example of why the tax bill and the cash do not match. Suppose an investor buys 1,000 units at $40, so the starting basis is $40,000. Over three years the partnership distributes $7,500 in cash and the K-1s allocate $2,000 of net taxable income. Basis is increased by the $2,000 of allocated income and decreased by the $7,500 of distributions, leaving $34,500. The investor has paid tax on $2,000 while receiving $7,500. If the units are then sold for $45,000, the gain is $45,000 minus $34,500, or $10,500. Notice what that figure contains: $5,000 of actual price appreciation, plus the $5,500 of distributions that were never taxed on the way through. The tax was deferred, not avoided, and part of the gain may be ordinary rather than capital under the unrealized-receivables rule.

Two practical consequences follow. An investor cannot judge the tax cost of an MLP from the distribution alone, and an investor who sells needs the sponsor's supplemental schedule, not just the brokerage's cost-basis figure, to report the sale correctly.

Pros

• Income is taxed once at the investor level rather than at the entity level and again on dividends, provided the qualifying-income test is met.
• Units trade on an exchange, so the interest is liquid in a way most partnership interests are not.
• Distributions that exceed allocated income defer tax rather than triggering it, which can suit an investor who expects a lower rate later.
• Access to infrastructure and natural-resource cash flows without the minimums of a private partnership.

Cons

• The Schedule K-1 is genuinely burdensome, arrives late, and can create tax filing obligations in states the investor has never set foot in.
• Taxable income can arrive in a year with no cash, and the SEC gives discharged debt in a restructuring as an example.
• Basis reduction stores up a larger gain at sale, and part of that gain can be ordinary rather than capital.
• Governance favors the sponsor: no independent board at the MLP, a lower standard of care than corporate shareholders receive, and incentive distribution rights that reward maintaining payouts.
• Concentration risk is inherent, because the qualifying-income test pushes the category toward a single sector and its commodity prices.
• Holding one in an IRA can generate unrelated business taxable income and a filing obligation for the account.