What it means
A master limited partnership has two kinds of partner. The general partner manages the business, while the limited partners put in money, hold tradable units and have no role in day-to-day decisions.
Because the entity is a partnership for tax purposes, it generally does not pay corporate income tax on its profits. Instead, income, deductions and credits pass through to each unit holder, who reports a share on a personal tax return and pays tax at their own rate.
MLP rules are most associated with the United States, where qualifying income is restricted mainly to natural resources and related activities such as transporting oil and gas. Other countries have different or no equivalent structures, so anyone outside the US should check local law.
MLPs distribute most of their available cash to unit holders, which is why the units tend to carry high yields. Investors look closely at distributable cash flow (the cash left after operating costs, interest and maintenance spending) and at the coverage ratio, which compares it with the amount actually paid out.
There are trade-offs. Unit holders receive complex tax paperwork, may owe tax on their share even if they sell at a loss, and some retirement accounts face limits on holding MLP income.
The general partner often has incentive distribution rights, which give it a growing share of cash as payouts rise.
In practice
Real-world examples.
Example
A retired engineer buys units of a pipeline MLP for its 6% yield. At tax time she receives a partnership statement and reports her share of income, which is partly sheltered by deductions. She keeps the statement with her records because it also affects what she owes when she sells.
Example
An energy company drops its midstream assets into a newly formed MLP. It keeps the general partner interest and a large unit stake, and receives growing cash payouts as the MLP buys more assets. The parent also gains a cheaper way to raise money for new projects than selling shares in itself.
Example
A credit analyst reviews an MLP whose distributions barely exceed its distributable cash flow. She flags that a modest drop in volumes could force a cut to the payout. Her report recommends watching the coverage ratio every quarter and not just the headline yield.
Formula
Calculation
Distribution yield = Annual distribution per unit / Unit price
Distribution coverage ratio = Distributable cash flow / Total distributions paid
A pipeline MLP has 50,000,000 units outstanding, pays $1.50 per unit each year and trades at $25 per unit. The yield is $1.50 / $25 = 0.06, or 6%. Total distributions are 50,000,000 x $1.50 = $75,000,000. If distributable cash flow is $90,000,000, the coverage ratio is $90,000,000 / $75,000,000 = 1.2, so the business earns 20% more than it pays out, which is a comfortable cushion.Case study
Seen in the real world.
Redstone Midstream Partners is an illustrative, fictional MLP that owns pipelines and storage tanks. Its contracts pay fixed fees for the volume of oil moved, so cash flows are steady and the units are popular with income investors.
When oil prices fell sharply, some producers cut output and pipeline volumes slipped. Redstone's coverage ratio fell from 1.3 to 1.0, meaning every dollar of distributable cash was being paid out and nothing was left to fund growth.
Management trimmed the distribution by 10% to restore a cushion and protect its credit rating. In this fictional story, unit prices dipped at first, then recovered once investors saw that the lower payout was safely covered. The episode taught Redstone's board to target a coverage ratio of at least 1.2 in future, even if that meant a lower yield in good times.
Watch out
Common mistakes.
- Treating a high distribution yield as proof that the investment is safe, when a high yield can signal that the market expects a cut.
- Forgetting the tax paperwork, since unit holders receive a partnership statement and not a simple dividend slip.
- Confusing distributions with profits, when a distribution is a cash payment that may include a return of capital.
Questions
People also ask.
Is an MLP the same as a stock?
No, units look like shares when traded, but holders are partners for tax purposes and receive distributions, not dividends.
Why are MLP yields often high?
The structure avoids entity-level tax and requires distributing most available cash. That can leave less to reinvest, so growth often relies on borrowing or issuing new units.
Do MLPs exist outside the United States?
Similar vehicles exist in some places, but the tradable partnership model with pass-through tax is most associated with the US. Check local rules before investing, and ask a tax adviser how any foreign partnership income would be reported.
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