The Tax Advantages of MLPs

Fact checked by Suzanne KvilhaugReviewed by Lea D. UraduFact checked by Suzanne KvilhaugReviewed by Lea D. Uradu

An MLP is a master limited partnership, but the title isn’t as interesting as what the MLP can accomplish from an investing standpoint. Its cash distributions are not taxed when unit holders receive them; they are tax-deferred, and you only pay taxes on the difference between the sales price and your adjusted basis.

MLPs are publicly traded partnerships that are listed on major exchanges such as the NYSE or Nasdaq. To qualify as an MLP, the partnership must earn 90% of its income from minerals and natural resources; namely from exploration, development, mining or production, processing, refining, transportation, and marketing. It may also earn certain passive income from interest, dividends, and property rent.

Key Takeaways

• A master limited partnership is an exchange-traded investment involved in the exploration, development, mining, processing, or transportation of minerals and/or natural resources.
• Its business and tax structures make it appealing to investors.
• MLPs aim to distribute consistent cash flows to unitholders.
• Distributions are a return on capital and remain tax-deferred until units are sold.
• The appreciation of unit value is taxed as a capital gain.

MLP Business and Tax Advantages

What’s most intriguing about MLPs is the unique business structure and tax advantages that the partnership offers.

Business Structure

MLPs are set up by their partnership agreements to distribute the majority of their cash flow to shareholders, officially called unitholders. This cash flow is what makes MLPs attractive to investors.

Most partnerships forecast what they expect to distribute in cash over the next 12 months, which offers some level of predictability for unitholders.

Tax Structure

One consequence of the MLP’s unique structure is that the partnership doesn’t pay taxes at the company level.

There are tax benefits for unitholders as well. Because the MLP is able to claim a variety of deductions, the partnership’s taxable income is often lower than the paid-out cash flows. This means the cash flow received by the unitholder is treated as a return on capital and therefore is tax-deferred (though not tax-free).

Tax Implications of MLPs

As a unitholder of an MLP, you’re providing capital to the venture and being rewarded with cash distributions from ongoing operations. This makes MLPs a good option to consider for retirees or anyone else looking for a consistent income stream.

As mentioned above, since distributions are a return on capital, they are mostly tax-deferred. But when you sell your MLP units, you’ll pay taxes on the difference between the sales price and your adjusted basis.

For example, say you purchase $100,000 worth of MLP units. You receive $4,000 in distributions and there is $3,000 in unit depreciation. You only have to pay taxes on the difference: $1,000. This is on both the federal and state levels.

Important

While distributions are nice, the return on capital has the effect of lowering your cost basis. If you hold your units for long enough, your basis could eventually reach zero. Once that happens, future distributions will be treated and taxed as capital gains in the year in which they are received.

Consequence of Selling Your MLP

The sale of an MLP could result in both a capital gain and ordinary income for the investor. Because the cash distributions are due to depreciation and other deductions that the MLP takes, those deductions are recaptured upon the sale of the units and are taxed as ordinary income. Any appreciation of the value of the units is taxed as a capital gain.

Investors will need to keep track of their K-1 schedules to figure out how much is capital gain and how much is ordinary income.

Potential for Tax Avoidance

Fortunately, there’s a loophole. If you use your MLP for estate planning, then you will receive a mostly tax-deferred income stream while also avoiding a big tax hit on the sale of your MLP units.

Here’s how it works. As long as you don’t cash out of the MLP, but bequeath it to a spouse or the next generation (via a will, living trust, or just transfer on death account), you won’t have to pay taxes on a very low-cost basis (which will stem from the MLP being held for a long period of time).

Better yet, your heir will inherit the MLP at a higher cost basis, which gets readjusted to the market price on the date of the transfer. This is known as a step-up in basis. And if your heir wants to sell the MLP right away, there will be no capital gains tax.

All good news so far, but as you already know, there’s no such thing as a perfect investment. MLPs, like anything else, have their drawbacks.

Drawbacks of MLPs

Filings

Ordinary dividends are required to be filed on Form 1099-DIV, but distributions from an MLP must be filed via Form K-1. This is much more complicated. That being the case, your accountant will charge you more for the work they have to do. This may just be a few hundred dollars, but depending on the size of your investment in an MLP, this can add up, since it must be done on an annual basis.

Another negative here is that many MLPs operate in more than one state. This means you will have to file in those different states. Fortunately, the state where you will find a lot of MLP opportunities does not have a state income tax: Texas.

Note

Alaska, Florida, Nevada, South Dakota, Tennessee, and Wyoming also have no income tax. New Hampshire has a tax on interest and dividend income only and Washington has a capital gains tax on high-earning individuals.

Net Losses

This isn’t the only disadvantage of investing in an MLP. You might be thinking that a net loss from the MLP units can offset your other income, but no.

Losses must be carried forward and used against future income from the same MLP. If the losses continue, then you can’t deduct those losses against other income until you sell your units in the MLP.

Popular MLP Investments

Overall, the positives outweigh the negatives for an MLP. This doesn’t guarantee success by any means, but thanks to tax advantages, it’s an investment vehicle to consider. For starters, here are two popular MLP investments on Wall Street:

• Enterprise Products Partners (EPD)
• Plains All American Pipeline (PAA)

If you prefer to keep things simple while being diversified, consider an MLP exchange-traded fund (ETF), such as Alerian MLP ETF (AMLP). As an ETF, it provides exposure to multiple MLP companies.

What’s Beneficial About an MLP?

The investment and tax consequences that arise from being a unitholder can be great benefits. First of all, there’s the potential for an ongoing flow of cash distributions. While there are instances where ordinary income tax is owed, MLP unit sales also result in a lower capital gains tax rate for investors.

What’s an Easy Way to Invest in MLPs?

For convenience and simplicity, consider an MLP exchange-traded fund. This gives you exposure to different MLPs and thus, diversity. Plus, you can focus your research on a single ETF rather than on a variety of MLPs.

Should I Avoid MLPs as Investments?

While the tax consequences of MLPs can be complicated, investors should consider more than that when deciding whether to invest (as they should for any investment). Compare the potential income stream and capital appreciation of units to taxes and fees. And consult with your financial and tax advisors for more input should you require it.

The Bottom Line

MLPs offer a cost advantage over regular company stocks since they’re not hit with a double tax on dividends. In fact, their cash distributions are not taxed at all when unitholders receive them, which is very appealing.

However, the longer an MLP is held, the more likely the cost basis will decrease, which increases your tax obligation after units are sold. One solution is to bequeath the MLP to your survivors as part of your estate. But even if you don’t take that route, the cash distributions that you’ll receive from an MLP usually outweigh taxable income.

Read the original article on Investopedia.