Why should investors consider MLPs? Securities paying income can help mitigate the effect of fluctuating stock prices. MLPs are an income-oriented investment; their organizational mandate is to pay out all earnings not needed for current operations and maintenance of capital assets to their unitholders in the form of quarterly cash distributions.
Many MLPs are also growth-oriented, striving to increase their distributions as often as is possible and prudent. In addition, MLPs are a tax-advantaged investment.
As explained below, investors pay tax only on their proportionate share of the MLP’s income, which is greatly reduced by their share of deductions; distributions are tax-deferred. Finally, most MLPs are in essential industries, providing energy and energy infrastructure, for which demand is likely to continue and increase.
What kinds of companies operate as MLPs? Due to the requirements of the tax code, the great majority of MLPs—about 80% by number, representing close to 90% of MLP market capital—are in energy-related businesses. The largest number of MLPs is in the midstream sector, which gathers, processes, transports and stores oil, natural gas and refined petroleum products.
How are MLP units different from corporate stock? The big difference is in how MLPs and their investors are taxed. Unlike corporations, MLPs and other partnerships are not considered as separate entities for tax purposes. Rather, MLPs and other partnerships are “pass-through” entities.
No tax is paid at the partnership level; partnership income passes through and is taxed only at one level—that of the individual partner. Since deductions such as depreciation and depletion are also passed through to individual partners, taxable income is often quite low. Most MLPs make quarterly distributions to their partners that will significantly exceed any tax owed.
What does that mean for MLP investors? Since the MLPs itself does not pay tax, it is able to pass along more of its earnings to its investors than a corporation. It does this in the form of quarterly cash distributions. From a tax standpoint, these distributions are treated more favorably than corporate dividends.