Basic Questions and Answers for Investors About Master Limited Partnerships (MLPs)

 

What is a Master Limited Partnership? (MLP)

 

A master limited partnership is a limited partnership that is publicly traded on an exchange that combines the tax benefits of a limited partnership with the liquidity of publicly traded securities. There are two types of partners in this type of partnership: The limited partner is the person or group that provides the capital to the MLP and receives periodic income distributions from its cash flow and the general partner is the party responsible for managing the MLP’s affairs and receives compensation that is linked to the performance of the venture. To qualify for the tax benefit, 90% of an MLP’s income must come from activities in real estate, commodities or natural resources such as mining, timber or energy production.

 

Are MLPs Similar to REITs and How do they Differ?

 

They are similar in that they do not pay income taxes, and their shares trade on the major stock exchanges, just like regular stocks. Both are yield-oriented investments that pass through income to investors. However, they are different in structure. Unlike REITs, which are a special type of corporation, MLPs are partnerships. REITs have statutory distribution minimums, while MLPs do not.

 

Are There Different Kinds of MLPs?

 

There are three basic kinds of MLPs: Publicly Traded Partnerships, Private Partnerships and Private Pre-Public Partnerships. Publicly traded partnerships trade on AMEX/NYSE or NASDAQ. Private Partnerships are typically held indefinitely as passive investment vehicles, such as oil and gas drilling programs. Private Pre-Public Partnerships are built to eventually trade in secondary private or public market transactions from day one.

 

What is Qualifying Income?

 

Interests and dividends, real estate rental income, income from natural resource activities such as oil and gas operations, income from commodity investments and capital gains derived from the sale of assets used to generate the types of income above.

 

Are These Investments Unsuitable?

 

In many instances, the answer is YES.  FINRA requires investment recommendations to be suitable.  The FINRA suitability rules require that a firm or associated person have a reasonable basis to believe a recommended transaction or investment strategy involving a security or securities is suitable for the customer. This is based on the information obtained through reasonable diligence of the firm or associated person to ascertain the customer’s investment profile. The rule states that the customer’s investment profile “includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs [and] risk tolerance,” among other information. A broker’s “recommendation,” which is based on the facts and circumstances of a particular case, is the triggering event for application of the rule.

The MLP recommendations were often highly unsuitable for clients at brokerage firms like Merrill Lynch, Morgan Stanley and Wunderlich Securities.  The MLP recommendations were concentrated energy sector bets.  In small concentrations, the recommendations may have been suitable.  Unfortunately, many clients of full service brokers concentrated very large percentages of client portfolios in oil and gas master limited partnerships. In those cases, the investors can sue the brokerage firm who recommended it and potentially recover their investment losses.

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