The MLP Structure: GP, LP, IDRs, and Distributions

Introduction

The master limited partnership (MLP) is a corporate structure that defined the midstream energy sector for over three decades. From the 1980s through the late 2010s, most midstream companies operated as MLPs, using the partnership tax structure to maximize cash distributions to unitholders and attract income-seeking investors. Understanding the MLP structure, its unique components (GP/LP dynamics, IDRs, distribution waterfalls), and why the industry has largely moved away from it is important for energy bankers because legacy MLP features still affect many midstream companies' financial statements, capital structures, and transaction dynamics.

An MLP is a publicly traded limited partnership that issues units (the partnership equivalent of shares) to public investors. The key structural distinction from a C-corporation is pass-through taxation: the partnership itself pays no federal income tax. Instead, income, deductions, and credits flow through to the individual unitholders, who report them on their personal tax returns via a Schedule K-1 (rather than the Form 1099 that corporate shareholders receive).

To qualify as a partnership for tax purposes, the MLP must generate at least 90% of its income from "qualifying sources," which include production, processing, storage, and transportation of natural resources and minerals. This qualifying income test is why MLPs are concentrated in the energy sector: midstream infrastructure operations easily meet the 90% threshold.

General Partner (GP) and Limited Partners (LP)

The GP manages the MLP's day-to-day operations, makes strategic and capital allocation decisions, and bears fiduciary responsibility for the partnership. The GP typically holds a small equity stake (approximately 2% of total partnership interests) but controls all management decisions. The LPs are the public unitholders who provide the vast majority of capital, receive quarterly cash distributions, have limited voting rights (primarily on major transactions like mergers), and bear no liability beyond their capital contribution. This separation of ownership (LP) and control (GP) creates agency dynamics that significantly affect midstream M&A and capital structure decisions.

The MLP issues units to the public through an IPO, raising equity capital to fund the acquisition or construction of midstream infrastructure. The partnership then distributes the cash flow generated by these assets to unitholders on a quarterly basis, with the distribution amount set by the GP based on available distributable cash flow. The distribution schedule is typically quarterly, and MLPs have historically offered yields of 5-10%, significantly higher than the dividend yields of comparable C-corp companies, which attracted a dedicated base of income-seeking retail and institutional investors. Unlike corporate dividends (which are paid from after-tax earnings), MLP distributions are paid from pre-tax cash flow (because the partnership pays no entity-level tax), which makes the gross payout higher than a comparably sized corporation could provide.

The most distinctive feature of the traditional MLP structure is the Incentive Distribution Rights (IDRs), which give the GP an escalating claim on the partnership's cash distributions as payouts to LP unitholders exceed specified thresholds.

A typical IDR waterfall works as follows:

At the highest split, the GP receives $0.50 of every incremental dollar distributed to the partnership, even though it owns only 2% of the equity. This "50/50 split" created enormous incentives for the GP to grow distributions (because the GP captured half of every dollar of growth) but also created a significant conflict of interest: the GP was incentivized to pursue growth at almost any cost (including over-leveraging the MLP, issuing dilutive equity, or making acquisitions at inflated prices) to push distributions higher and increase its IDR income.

Dropdown Transaction

A transaction in which a GP sponsor sells midstream assets from its corporate balance sheet to the MLP at a negotiated price. The MLP funds the acquisition through a combination of new unit issuance (equity dilution to existing LPs) and incremental debt. Dropdowns served two purposes: they provided a predictable growth pipeline for the MLP (supporting distribution increases that maximized the GP's IDR income) and allowed the sponsor to recycle capital (converting midstream asset ownership into cash that could be redeployed). The fairness of dropdown pricing was a recurring source of GP/LP conflict because the GP, which controlled both entities, had an incentive to sell assets to the MLP at inflated prices.

Many MLPs were sponsored by large energy companies that served as the GP. The sponsor would construct or acquire midstream assets in its own corporate entity and then "drop down" those assets into the MLP at a negotiated price, funded by the MLP issuing new units (equity) and debt. These dropdown transactions created a pipeline of growth for the MLP (which needed to grow distributions to maximize the GP's IDR income) and allowed the sponsor to recycle capital (selling midstream assets to the MLP and redeploying the proceeds into new projects or other corporate uses).

The tax pass-through structure provides MLP unitholders with two advantages. First, no double taxation: partnership income is taxed once at the unitholder level rather than being taxed at both the entity level (corporate tax) and the investor level (dividend tax). Second, tax deferral: because midstream assets generate significant depreciation deductions, a large portion of MLP distributions (often 70-90%) is classified as "return of capital" rather than taxable income, deferring taxes until the unitholder sells the units.

However, the K-1 tax form creates complexity that discourages many institutional investors from holding MLPs. Tax-exempt investors (pension funds, endowments) face unrelated business taxable income (UBTI) when holding MLP units, which can trigger tax obligations for otherwise tax-exempt entities. Foreign investors face withholding tax complications. These tax frictions limit the MLP investor base and reduce liquidity, which is another reason the industry has shifted toward C-corp structures.

Even though most large midstream companies have converted to C-corp structures, the MLP legacy continues to affect energy banking in several ways: