PRUDENTIAL INVESTMENTS » MUTUAL FUNDS
UNDERSTANDING MASTER
LIMITED PARTNERSHIPS
OVERVIEW OF MLPS AND MLP MUTUAL FUNDS
WHITE
PAPER
This paper describes the basic structure of master limited partnerships
(MLPs), typical business operations of energy MLPs, and the resulting tax
implications associated with C Corporation mutual fund entities—the only
mutual fund structure permitted to have 100% MLP exposure.
MASTER LIMITED PARTNERSHIPS
BASIC STRUCTURE
The MLP Structure
MLP Qualification
An MLP, like other partnerships, consists of a general
partner (GP) and limited partners (LPs) (i.e., unitholders).
An MLP is considered a flow-through entity (FTE), which
means it is a legal structure whereby income, gains, losses,
and deductions can flow directly to unitholders. Therefore
the partnership itself is not taxed on income at the
corporate federal, state, and local levels.
The general partner manages the daily operations of the
partnership, usually holds a 2% stake in the MLP, and is
eligible to receive incentive distribution rights (IDRs). The
IDR may start at a low percentage, say 5%, but can ramp
up to as high as 50% as distributable cash flow grows.
IDRs result from the MLP’s net income that exceeds the
amounts necessary to pay for the partnership’s quarterly
required distributions, and are usually paid in the form of
increased equity claims. They provide the general partner
with performance-based pay for successfully managing
the MLP.
HYPOTHETICAL INCENTIVE DISTRIBUTION RIGHTS STRUCTURE
—
LP Distribution Per
Unit
Tier 1
Below $1.00
Tier 2
$1.00 to $2.00
80
20
Tier 3
$2.00 to $3.00
65
35
Tier 4
Above $3.00
50
50
LP
98%
GP
2%
Limited partners provide investment capital, have no role
in the partnership’s operations and management, and
typically own the remaining 98% stake in the MLP in the
form of units. MLP units are equivalent to common shares
of a corporation and allow the unitholder to receive cash
distributions.
MLP units are equivalent to common shares of a
corporation and allow the unitholder to receive cash
distributions based on the MLP’s cash flows, which are
generated by its underlying assets.
To qualify for MLP status and the associated tax benefits,
a partnership must generate at least 90% of its gross
income from what the Internal Revenue Service (IRS)
deems “qualifying” sources.
MLP Cash Flow and Cash Distributions
An MLP’s cash flow represents the partnership’s earnings
before interest, taxes, depreciation, and amortization
(EBITDA) and are typically paid out to unitholders quarterly.
Cash distributions of a flow-through entity will have two
taxable components: (1) ordinary income less depreciation;
and (2) return of capital (ROC), which is the portion of the
original cost basis that has been amortized for depreciation.
It is possible for an MLP’s entire taxable income to be
offset by depreciation and amortization resulting in a cash
distribution that is 100% ROC. As an MLP exhausts its
depreciation and amortization sources, the percentage
of the cash distribution made up of taxable income will
increase.
Generally speaking though, MLP cash distributions will
equate to roughly 0%–20% taxable income, which is taxed
immediately at ordinary income tax rates; and 80%–100%
ROC that is treated as a tax credit until final sale. When
the MLP is sold, the sum of all ROC cash distributions will
become taxable at capital gains rates—this is referred to as
depreciation recapture.
But unlike common shares of a corporation, MLP units do
not give the unitholder voting rights over the operations and
management of the partnership.
In addition to cash distributions, both the GP and the
unitholders are subject to a portion of the MLP’s tax
liabilities, proportional to their interest level in the MLP.
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MASTER LIMITED PARTNERSHIPS
Energy MLPs
Energy MLP assets are part of the crude oil and gas value
chain, which can be grouped into the following categories
depending on the type of operations the underlying MLP
assets conduct: Upstream, Midstream, and Downstream.
Upstream operations are primarily engaged in exploration,
recovery, development, and production of crude oil, natural
gas, and natural gas liquids (NGLs).
Downstream operations include distribution of the
consumable product to residential, commercial, industrial,
and agricultural customers.
Midstream operations are involved in gathering, storing,
marketing, and transporting petrochemicals. Midstream
MLPs do not profit through the sale of any commodity, but
rather by providing a service or means of transportation
for the commodity holder. This is typically referred to as a
“tollbooth” style of operation—similar to income received
from a monthly parking permit or highway toll.
Many MLPs today focus on midstream operations because
relatively long-term contracts associated with “tollbooth”
operations can generate stable cash flows that are less
correlated with the short-term price volatility associated
with the sale of either raw or refined petrochemicals.
Energy MLP Assets Are Part of the Crude Oil and Gas Value Chain
Upstream
• Producers
• Exploration and
production
{
Midstream
• Gather
• Store
• Transport (e.g., pipeline, barges)
• Processing
• Marketing
GAS PROCESSING
FRACTIONATING
TRANSPORTATION
CRUDE OIL GATHERING
2
STORAGE
STORAGE
Downstream
• Home
• Refineries
• Chemical plants
• Car
• Gas station
{
Investing in MLPs
Publicly Traded MLPs
C Corp Structured MLP Mutual Funds
Investors can achieve direct exposure to MLPs by
purchasing shares of a publicly traded partnership, the
same way they would purchase common stock shares of
a publicly traded corporation. One significant difference
between MLP and common stock shares involves investor
tax implications.
Mutual funds that fail to qualify as a RIC are instead treated
as a regular corporation, or a C Corporation (C Corp). A
C Corp mutual fund has no holding restrictions and
therefore is the only mutual fund structure that could
potentially offer a “pure play” MLP investment.
Publicly traded corporations distribute simple 1099 tax
forms to common stock shareholders, while MLP entities
distribute more complex K-1 tax forms. In addition to
federal income taxes, an MLP investor is required to file
state and local income tax returns (even if no taxes are
owed) in some or all of the various jurisdictions in which
an MLP conducts business or owns property.
MLP Mutual Funds
Mutual funds have been allowed to invest in MLPs since
2004. Many investors prefer the single 1099 tax form
associated with a mutual fund over the onerous tax
implications for individual MLP investments. Depending on
how a mutual fund is structured for U.S. federal income tax
purposes, there may be restrictions on MLP investments.
C Corp structured mutual funds are subject to federal, state,
and local taxes on an entity level (i.e., the Fund level). This
tax liability is a combination of ordinary income and realized
capital gains the C Corp earns on its investments and its
unrealized capital gains captured by the entity’s Net Asset
Value (NAV) as a deferred tax expense.
Mutual Fund Shareholder Tax Effects
Regardless of whether an individual invests in a C Corp or
a RIC structured mutual fund, shareholders are required to
pay taxes on all fund distributions that are not deemed ROC.
This includes ordinary income, such as from dividends, and
net realized capital gains at the time of final sale.
RIC Structured MLP Mutual Funds
Most traditional mutual funds are structured as Regulated
Investment Companies (RICs) and are shielded from
entity-level taxation. But in order to maintain this favorable
tax structure, a RIC must, among other requirements,
limit the amount it can invest in “qualified publicly traded
partnerships” (i.e., MLPs) to no more than 25% exposure.
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MASTER LIMITED PARTNERSHIPS
Entity-Level Tax Consequences Associated With C Corp Structured MLP Mutual Fund Investing
MLP
Holdings
• Unlike typical common equity shares, MLPs are flow-through entities and
can avoid income taxes if they generate at least 90% of their gross income from
qualifying sources.
• MLPs pass on a portion of income, deductions, and credits to each unitholder
that is reported through an IRS Schedule K-1.
• MLPs will generate state and local income tax consequences for its unitholders.
-
C Corp
structured
Mutual Fund
• C Corp structured mutual funds can make investments in MLP stocks, and
receive a portion of income, deductions, and credits distributed from each MLP
holding that is reported through each holding’s K-1.
• Unlike most mutual funds, a C Corp Mutual Fund is taxed on corporate federal,
state, and local income taxes and issues a single 1099 to its shareholders.
• Similar to other mutual fund structures, C Corp Mutual Funds pay dividends.
MUTUAL FUND
SHAREHOLDER
4
Taxation on Cash Distributions:
Taxation at Final Sale:
• Qualified Dividend Income (QDI) is taxed
at 15% or 20%
• Share Price Appreciation is taxed
at capital gains tax rate
• Return of Capital (ROC) is tax deferred
until final sale
• Depreciation Recapture (the sum of
past ROC payments) is also taxed
at capital gains tax rate
Risk Information
Investing involves risk. Some investments are riskier than
others. The investment return and principal value will
fluctuate, and shares, when sold, may be worth more or
less than the original cost.
MLP RISKS
MLPs and MLP-related investments are subject to
complicated and in some cases unsettled accounting,
tax, and valuation issues, as well as risks related to limited
control and limited rights to vote, potential conflicts of
interest, cash flow, dilution, and limited liquidity and risks
related to the general partner’s right to force sales at
undesirable times or prices.
Fund risks also include interest rate risk, where its value
will decline as interest rates rise; nondiversification, where
a loss resulting from a particular investment will have a
greater impact on the Fund’s return, and investments in
initial public offerings (IPOs). These risks associated with
the Fund are more fully explained in the prospectus and
summary prospectus. These risks may increase the Fund’s
volatility. There is no guarantee the Fund’s objective will be
achieved. Asset allocation and diversification do not assure
a profit or protect against loss in declining markets. There
is no guarantee that the expectations will occur.
MLP risks relating to their complex tax structure include
losing their tax status as a partnership, resulting in a
reduction in the value of the MLP investment and lower
income to the Fund.
MLP MUTUAL FUND RISKS
Unlike traditional RIC open-end mutual funds, C Corp
open-end mutual funds are taxed as regular corporations
and are subject to U.S. federal income tax on its taxable
income at the graduated rates applicable to corporations,
as well as state and local income taxes. Any deferred
tax expenses or assets incurred by underlying MLP
investments must be estimated to be included in a mutual
fund’s daily NAV. Typically tax expenses are estimated and
readjusted daily, and independently audited on a quarterly
basis. Differences in estimated vs. actual tax liability/benefit
may potentially result in a material impact on a mutual
fund’s NAV.
A significant portion of the Fund’s distributions will consist
of return of capital for U.S. federal tax purposes, which
reduces a shareholder’s adjusted cost basis in the Fund’s
shares and impacts the amount of any capital gain. Many
of the Fund’s MLP investments are in the energy sector,
which subjects the Fund to a greater degree to the risk of
loss as a result of adverse economic, business, regulatory,
environmental, or other developments affecting industries
within that sector than if the Fund’s investments were more
diversified across different industries.
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MASTER LIMITED PARTNERSHIPS
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