Master limited partnerships
A master limited partnership, or MLP, is a publicly traded corporate structure operating in the energy sector, typically natural gas pipelines. MLPs pass on the vast majority of their income to investors, meaning that these companies usually offer huge dividend yields.
MLPs are designed as tax pass-through entities so that dividends are not taxed at the corporate level, and they must provide a quarterly distribution. They offer tax savings to individual investors, says Sanjoy Ghosh, chief investment officer of Covestor.com. "The MLP itself is not getting taxed, but the owners of the partnership are. This includes common stockholders, who are taxed when they get the distribution," he says.
Only a portion of each distribution is taxed at ordinary income rates while the rest is considered a return of capital. However, tax record-keeping is essential since the investment's cost basis changes with each distribution.
When searching for an MLP in a portfolio, Ghosh says that most investors look for more than high dividends -- they usually want to see a long history of having sufficient cash on hand. "This doesn't mean cash-rich MLPs are risk-free, though. They are sensitive to interest rates, and a lot of these assets become overpriced when a lot of investors are desperately looking for passive income," Ghosh says.