Master Limited PartnershipWhat exactly is a Master Limited Partnership (usually abbreviated as MLP) and how does it help produce passive income? Here's what Wikipedia has to say: Master limited partnership (MLP) is a limited partnership that is publicly traded on a securities exchange. It combines the tax benefits of a limited partnership with the liquidity of publicly traded securities. First of all, it's a Partnership (i.e., not a corporation), which means that you buy Units (instead of shares) to become a Limited Partner (instead of a shareholder). It also means that you get a K-1 form at the end of the year instead of a 1099-DIV. One major implication of the partnership structure of an MLP is that the profits and losses are not taxed at the corporate level. Instead, they are "passed through" to the Limited Partner (or Unitholder), who pays taxes on them. They tend to have high yields for this reason, which is why we like them for generating passive income. Apart from these technical differences, there is no difference between buying Units in a Master limited partnership and buying stock in a corporation. BusinessesSince the partnership part of the business is only relevant for accounting and tax purposes, practically any business may be formed & operated as a partnership. Thus you will find that if you searched for MLPs, you will find a variety of businesses listed under that category. However, one particular sector of the US stock market has historically dominated the MLP niche and that is pipelines - and that is what we are going to concentrate on here. PipelinesPipelines play a vital role in the running of our economy. They transport crude oil and natural gas from where they are produced (or from the port where they are brought into the country) to where they are used. Pipelines typically do not "own" the oil or gas. They just transport them and get paid for that. As a result, in general they tend to be independent of the actually price of the oil or gas.Also, since it costs a lot of money to build a pipeline (the construction costs plus legal costs associated with obtaining permits & rights of way along the route for the construction), once a pipeline is built, they tend not to have competitors! They are called Wide Moat companies for that reasons. Return of CapitalThe US Congress recognizes the importance the oil and gas industry plays in keeping the economy running and provides significant tax breaks to the industry. The pipelines get one break called the Return of Capital break. Part of the dividend is considered a return of capital and thus is not taxed. I own a few units of an MLP called EV Energy Partners, L.P. (EVEP), and I get paid a dividend every quarter. But in the last few quarters I have not had to pay any tax on that dividend because ALL of it was classified as a Return of Capital! This is just another reason why I think pipelines belong in a high-yield portfolio. [NOTE: This is not a free lunch, however. This Return of Capital gets reflected in lowering your cost-basis, and you end up paying taxes on it when you sell the shares.]
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