What Is Wrong With The MLP Model?

Master limited partnerships emerged as a popular investment vehicle over the past decade. Here’s why investors have soured on the sector.

The first master limited partnership (MLP) was formed by Apache Oil Company in 1981. In 1987 Congress legislated the rules for publicly traded partnerships in Internal Revenue Code Section 7704.

MLPs slowly gained in popularity during the 1980’s and 1990’s, with about two new MLP IPOs each year. Then, in the 2000’s, the popularity of the MLP model began to soar. There were six new MLP IPOs in 2004, ten in 2005, and eighteen in 2006.

The recession and oil price crash of 2008-2009 briefly derailed the momentum for new MLPs, but demand began to surge again in 2010. In 2013, an all-time high of twenty new MLPs hit the IPO market, but then popularity again began to wane as oil prices crashed in 2014.

The MLP Advantage

An MLP issues units rather than shares, and passes profits to unit holders in the form of periodic distributions. Historically, the big advantage for MLP investors is that MLPs aren’t taxed at the corporate level. This arrangement avoids the double taxation of corporate income and dividends affecting traditional corporations and their shareholders. All things being equal, this structure should deliver more money to unit holders.

But the distributions aren’t fully taxed either. Because of the depreciation allowance, 80% to 90% of the distribution is considered a “return of capital” and thus not taxable when received. Instead, a return of capital reduces the cost basis of an investment in the MLP.

The rest of the distribution—typically 10% to 20% —is taxed at the recipient’s income tax rate. Being able to defer the rest of the tax until the investment is sold is a big advantage, since the income can be reinvested to generate compound returns that could more than pay for the eventual tax bill.

When you ultimately sell the units or the cost basis drops to zero, a portion of the capital gain is taxed at the special long-term capital gains tax rate, and the remainder will be taxed at your normal income tax rate.