A while back I wrote about Duncan Energy Partners (DEP: chart, web, Y!), and how their structure as a Master Limited Partnership (MLP) could work to an investors favor.

So what is an MLP, and how does its structure work to your advantage?

A MLP is a unique investment that combines the tax benefits of a limited partnership (LP) with the liquidity of common stock, and as such maintains the ability to trade on an open stock exchange. To qualify for the MLP structure, the company must earn 90% of its income through activities, or interest and dividend payments relating to natural resources, commodities or real estate.

MLPs contain two business entities: the limited partner (that’s you and me, the little guy) and the general partner (GP) who oversees the operation. The GP receives incentive distributions rights (IDRs) based on performance for doing a good job at managing the operation. The GP typically receives a minimum of 2% of the LP distribution, but as payment to LP unitholders increases, the percentage take of the GP through IDRs increases too, often to a maximum of 50%. So it’s in the general partners best interest that the operation do well. This could be likened to the fee that a mutual fund takes for running the fund itself.

So what’s in it for me? Typically a fat distribution. Notice I said “distribution” and not dividend. This is because, much like a closed-end ETF, only part of your distribution is actually a dividend.

Cash distributions are based on the MLP’s distributable cash flow (DCF), similar to free cash flow (FCF). Unlike dividends, these distributions are not taxed when they are received; instead, they are considered reductions in the investment’s cost basis and create a tax liability that is deferred until the MLP is sold.

Fortunately for investors, MLPs generally have much higher distributable cash flow than they have taxable income. This is a result of significant depreciation and other tax deductions, and is especially true of natural gas and oil pipeline and storage companies like Duncan Energy. Investors then receive higher cash payments than the amount upon which they are taxed, creating an efficient means of tax deferral. Wachovia Securities estimates that the taxable income passed on to investors often is only 10-20% of the cash distribution, while the other 80-90% is deemed a return of capital and subtracted from the original cost basis of the initial investment.

So the short end is that you see a healthy return on your investment through a tangible working asset, and only part of that return is taxed as income.

It is in this regard that I prefer a company like Duncan Energy Partners over the likes of CLM. DEP has a working interest in tangible assets that one can keep track of. If the company does better over the long run, you should see more of a dividend than a return of capital.

This is a bit long-winded for a TCOB post, but hopefully it explains the nuts-and-bolts of a MLP. If you think it may work to your investment strategy, do a little more research on the subject before you jump in!

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