Understanding “Master Limited Partnerships”
“Master limited partnerships” are a complicated-sounding investment. And with good reason. MLPs are often advertised as can’t-miss, low-risk securities, but the truth is many investors simply do not understand how they work.
A master limited partnership—officially called a “publicly traded partnership” by the Internal Revenue Service—basically combines the legal structure of a limited partnership with the liquidity of a traded security. Typically we associate securities with corporations, where investors purchase shares of stock and receive periodic dividends. A master limited partnership is not a corporation. As the name implies, it is legally considered a partnership (although some MLPs are organized as limited liability companies). This has important tax implications. A corporation’s profits are taxed twice: once at the corporate level and then again on the individual shareholder’s dividends. In contrast, a partnership is not taxed as an entity; the individual partners simply pay tax on their share of the profits.
Unlike most traditional partnerships, shares (or “units”) of a master limited partnership can be bought or sold on a stock exchange. The owners of these units are considered limited partners. They have no role in the management of the partnership, which is vested in one or more general partners.
The MLP must make periodic payments to each of the limited partners. Any payments above the partnership’s income are not treated as dividends, but rather a “return of capital.” For example, let’s say you buy one unit of a MLP for $1,000. At the end of the year, the MLP makes a distribution of $200 per unit. If $100 of this distribution is treated as a return of capital, the cost basis for your unit drops from $1,000 to $900. If you then sell the unit for, say, $1,100, you would owe tax on a capital gain of $200 (in addition to the income tax owed on the $100 of income from the initial distribution).
Are There Risks to an MLP?
Master limited partnerships are only allowed to legally operate in certain industries, mostly having to do with the natural resources infrastructure like energy pipelines. The idea is that MLPs operate businesses that produce a consistent cash flow in order to meet regular distributions to unitholders. MLPs are frequently touted for their higher rates of return relative to more conservative investments like bonds or mutual funds.
But the need to maintain a high cash flow carries significant risks. MLPs must access a large amount of capital, usually in the form of debt, to finance the growth necessary to support payments to unitholders. This means a general economic downturn, which often negatively impacts credit markets first, can have a significant effect on the value of a MLP.
Furthermore, any decline in commodity prices for items like gasoline can have a ripple effect on MLPs, which often finance the underlying energy infrastructure. The growth of MLPs is tied to an increase in demand for things like drilling activity. Any decline, whether due to market forces or government regulation, can severely alter the MLP’s cash flow and thus seriously impact a MLPs share price
Recently, we have seen significant and precipitous declines in values of several well-known MLPs. Including LRR Energy L.P. (LRE), BreitBurn Energy Partners L.P. (BBEP), Legacy Reserves L.P. (LGCY), QR Energy L.P. (QRE), and Mid-Con Energy Partners L.P. (MCEP)
Of course, no investment is without risk. But there may be times when your losses are not simply the result of bad luck. If you have any questions regarding your investment in a Master Limited Partnership or believe you have been the victim of fraud with respect to any kind of publicly traded security, contact Boca Raton lawyer Gregory Tendrich, P.A., today to discuss your legal options.