In today’s troubled markets, investors face considerable challenges, as many of the tried and true formulae are coming up short. Equity investors are finding that continuing increases in share prices are no longer something they can count on. As a result, many investors are taking refuge in income-oriented investments, such as bonds, utilities, and dividend paying corporate stocks. And of course for those investors in or approaching retirement, investments providing income have always been in vogue.

An option that many investors overlook or turn away from is master limited partnerships, or MLPs. MLPs which pay quarterly cash distributions that often grow over time, represent an asset class that deserves attention. However, MLPs are often not well understood and can seem a little too exotic for the average investor. Taking the time to learn the basics about MLPs could well prove to be time well spent.

What is an MLP?

A more accurate name for an MLP is a publicly traded partnership, or PTP. It is, quite simply, a limited partnership (or sometimes an LLC choosing partnership taxation), that is traded on the public exchanges (i.e., NYSE, NASDAQ, Amex) just like corporate stock. A share in an MLP is called a “unit,” and its investors are “unitholders.”

A limited partnership consists of a general partner and the limited partners. The general partner manages the day-to-day operations and holds a small percentage ownership stake. The limited partners (or common unitholders) have no role in the partnership management but rather provide the capital and receive cash distributions (LLCs are slightly different; the owners are all members; some of them may manage the LLC, but there Master Limited Partnerships: An Investment You May Have Overlooked is no general partner).

The biggest difference between an MLP and a corporation is that as a partnership, the MLP does not pay corporate tax. This allows it to distribute more of its earnings to investors. A partnerships is not considered to be a separate taxable entity but is treated as a “passthrough” entity comprised of all its partners. The partnership’s income is allocated for tax purposes among all the partners, who pay tax on their share.

Not every business that chooses to can operate as a publicly traded partnership. The tax code strictly limits the right of partnerships to be publicly traded without paying corporate tax. In order to qualify for partnership tax treatment, a PTP must receive 90 percent of its income from specific sources such as natural resources activities, interest and dividends, real estate rents and income and gain from commodities.

As a consequence most of the approximately 97 PTPs trading today on the major exchanges—about 80 percent-- are engaged in natural resource based businesses. There are also some PTPs in real estate, investment, and other businesses, as well as commodities, but it is the natural resources group that most people think of when they say “MLP.”

The MLPs in this group are engaged in a variety of activities. The majority of MLPs fall into the oil and gas midstream sector; i.e., gathering, processing, refining, compression, transportation in pipelines, and storage in terminals. Other MLPs are in engaged in exploration and production of oil, gas, and minerals; propane and heating oil marketing and distribution; transportation of petroleum products on tankers and barges; and coal leasing and production, as shown in Figure 1 below.

Why should I consider MLPs as an Investment?

There are several reasons to consider MLPs as an investment, most of them having to do with their partnership tax treatment.