Commodity Master Limited Partnerships

If you’re interested in investing in companies that are involved in the production, transformation, and distribution of commodities, one of the best ways to do so is to invest in a master limited partnership (MLP). MLPs are a great investment because of their tax advantage and high cash payouts.

MLPs are public entities that trade on public exchanges. Just as a company issues stock on an exchange, an MLP issues shares that trade on an exchange. You can get involved in an MLP by simply purchasing its shares on an exchange. This is why an MLP is also called a publicly traded partnership (PTP).

Although most MLPs trade on the New York Stock Exchange (NYSE), a few MLPs also trade on the Nasdaq National Market (NASDAQ) and the American Stock and Options Exchange (AMEX).

The shares that an MLP issues are called units, and investors who own these units are known as unit holders. When you invest in an MLP, you’re essentially investing in a public partnership. This partnership is run by a general partner for his benefit and, more important, for that of the limited partners (which you become when you buy MLP units).

One of the reasons MLPs are so great for commodities investing is that, unlike regular corporations, they’re taxed only once. Many publicly traded companies are subject to double taxation: They’re taxed at the corporate level as well as at the shareholder (individual) level. Not so with MLPs.

Because of congressional legislation, any MLP that derives 90 percent or more of its income from activities related to the production, distribution, and transformation of commodities qualifies for this tax-exempt status.

The income that an MLP uses to qualify for tax advantages is known as qualifying income. If an MLP can prove its qualifying income, it can “pass through” its income tax-free to its shareholders, who are then responsible for paying whatever taxes are appropriate for them. This is why MLPs are sometimes referred to as pass-through entities.

Suppose that you’re in a 35 percent tax bracket. You invest $1 in an MLP and $1 in a corporation. The corporation needs to generate $2.20 in income to distribute $1 of after-tax profits to you. The MLP, thanks to its favorable tax treatment, has to generate only $1.54 in income to give you back $1 of after-tax profits.

This tax status gives MLPs a competitive advantage over other publicly traded entities when they compete for assets. An MLP simply doesn’t have to generate as much cash flow as a corporation to distribute similar levels of after-tax income to shareholders — and this fact has two possible implications.

First, if it wants, the MLP can afford to overpay for an asset and still generate healthy cash flows for its investors. Alternatively, it can purchase an asset at a similar price from a competing corporation but generate more cash flow to investors because of its favorable tax treatment.

MLPs are required to distribute all available cash back to unit holders on a quarterly basis. When you own an MLP, you receive a K1 tax form, which is similar to the 1099 tax form you receive from a corporation.

Be sure to inform your accountant of your MLP investments in advance, because most K1 forms aren’t mailed out to shareholders until February. This gives you only a few weeks to account for the MLP income in your taxes.

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