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What are master limited partnerships?

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Highlights
  • MLPs generally have a conservative capital structure and stable cash flows.
  • Master limited partnerships offer yields that often exceed 6 percent.
  • Though MLPs have tax advantages, calculating the taxes is complicated.

Master limited partnerships, or MLPs, represent an attractive investment opportunity, as they provide tax-advantaged assets with lofty dividends and buoyant prospects for growth.

MLPs trade on exchanges like stocks do, though investors buy units of partnership rather than stock shares.

Because MLPs are limited partnerships, they don't face double taxation. MLPs are subject to no taxes at the corporate level. Most companies, by contrast, are obligated to pay corporate income taxes. And after that, shareholders pay taxes on the dividends they receive as well.

MLPs are required by law to provide a quarterly distribution. In October, the yields for many MLPs stood higher than 6 percent. Other investments that offer both income and safety generally don't yield that much.

"For income investors looking for something that beats Treasuries, corporate bonds, utilities and REITs (real estate investment trusts), I think MLPs win hands down," says Jason Stevens, an MLP analyst for Morningstar, a Chicago-based investment research firm.

Most MLPs are involved with the transportation, storage and distribution of energy products, with natural gas pipelines making up most of the asset class. That's where safety enters the equation, as the pipeline owners generally have long-term contracts providing them fees for transporting the gas.

"The pipeline is like a giant toll road -- think of it as a turnpike," says Bob Payne, managing director of Payne Capital Management, a financial advisory firm in Blue Bell, Pa.

So MLPs generally boast a healthy balance sheet and steady cash flows.

The tax advantage

The tax accounting for MLPs' quarterly distributions is quite favorable. In most cases, only 10 percent to 20 percent of the distribution counts as net income. So shareholders would pay their regular income tax rate on this portion.

The rest of the distribution is considered a return of capital. So this portion isn't subject to tax. Rather it is taken out of the holder's cost basis.

Long-term MLP investors may see their cost basis ultimately drop to zero. When that happens, all distributions are subject to tax, though in many cases it's a capital gains tax rather than a regular income tax.

That makes quite a difference, as the long-term capital gains tax rate tops out at 15 percent through 2012, while the top income tax rate totals 35 percent.

"The key advantage of MLPs is that they offer a highly tax-shielded distribution that has a pretty good track record of growing 4 (percent) to 8 percent a year," Stevens says. "When you have 6 (percent) to 7 percent yields growing at that level, you're enjoying a total return that beats out most investments in this market environment."

While demand for natural gas does ebb and flow, its use is so ubiquitous that consumption will keep rising, experts say. "As long as we continue to heat our houses and turn on the lights, the volume of natural gas won't disappoint," Stevens says.

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