Demand is growing for master limited partnerships, thanks to the increasing use of natural gas, 6% yields and proposed legislation to expand their use for renewable energy projects.

Master limited partnerships are business partnerships, often listed on a U.S. stock exchange. Limited partners generally invest in a partnership run by someone else, typically a "general partner." However, unlike an investor in stocks, limited partners have no voting rights. Plus, a limited partner, also known as the "unit holder," generally pays fees to general partners out of distributions.

Master limited partnerships are attractive because they avoid the double taxation of publicly traded corporate dividends. They also pass depreciation and expenses through to investors. Some 80% of the distribution of income may be considered a return of capital. And those distributions can cushion master limited partnership price declines in down markets.

"The broader outlook for the [MLP] asset class remains strong," says James Cunnane Jr., co-manager of the closed-end Nuveen Energy MLP Total Return Fund. "We believe the fundamental strength of the domestic energy story." Master limited partnership returns, he predicts, will average 8% to 10% annually over the long term.

The big news is that bipartisan legislation, proposed by Senators Chris Coons (D., Del.) and Jerry Morgan, (R., Kan.), seeks to expand the use of master limited partnerships from fossil fuel-based energy projects to renewable energy products. The tax benefits of master limited partnership profits, which are taxed at the partnership level instead of at the corporate tax level, should increase renewable energy investments. And hydraulic fracturing of natural gas and new extraction methods have been lowering production costs while increasing supplies.

As of midyear 2012, master limited partnerships were in the red after a collapse in natural gas prices and a drop in crude oil prices. Over the shorter term, they are vulnerable because of their strong correlation to the price of oil.

The Alerian MLP Index was down 8% for the year as of June, according to Alerian, the Dallas-based data company that publishes it. But for the year ended in June, that same index outperformed the S&P 500 index-10% versus 8.50%. Over the past five years ended in June, the Alerian index has grown at a 12% annual rate, compared with the piddling 2% annual return of the S&P 500.
Many master limited partnerships in energy pipelines and storage have been hailed for tax-advantaged income, quarterly dividends and attractive performance.

But these investments come with a number of risks. When interest rates rise, master limited partnership prices typically drop. Distributions are not guaranteed. Investors may have no power to remove bad management. Bad news about energy, the sector of many master limited partnerships, may hurt prices. Debt-burdened partnerships could have a tough time borrowing. Limited partners may have to foot the bill for higher interest rates.

A partnership may depend upon negotiated land leases for energy pipelines. Meanwhile, tax laws could change next year, wiping out tax advantages.

In addition, clients still may owe taxes, which can prove quite complex because they must get K-1 statements rather than 1099 tax forms. Investors with a master limited partnership in a retirement savings account still may owe Uncle Sam for unrelated business taxable income.

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