What Are the Tax Implications of Owning a Master Limited Partnership?

A Master Limited Partnership (MLP) is a hybrid between a partnership and a publicly traded company. There are significant tax advantages to owning MLP units. However, despite these benefits, MLPs may not be the ideal investment for an Individual Retirement Account (IRA).

Understanding Master Limited Partnerships

MLPs offer significant liquidity for investors. An investor can buy and sell units through a national stock exchange. Many MLPs operate capital-intensive businesses, such as oil and gas pipelines and storage facilities—the energy sector. Congress limited the use of MLPs to entities operating in certain sectors in 1987. This limitation includes those operating businesses associated with natural resources. MLPs issue units, as opposed to shares, as standard companies do. An investor who buys units in an MLP is considered a limited partner in the business. The business end of the MLP is operated by the general partner.

Distributions from MLPs to unit holders receive favorable tax treatment under the IRS code.An MLP is a pass-through entity, and partnership income is only taxed at the level of the partner. Distributions are not taxed when they are received, unlike stock dividends, which are taxed the year they are realized. Instead, the distributions are considered a reduction in the cost basis of the MLP investment. If you hold the MLP long enough and your cost basis reaches zero, distributions are taxed as capital gains in the year of distribution.

Tax Liability

The tax liability from the distributions is only realized when the interest in the MLP is sold. The delay in taxation causes the MLP to be a tax-deferred investment. When you eventually sell all of your shares, appreciation of the units will be treated as capital gains, not ordinary income.

Since MLP tax liability is deferred, it is not the best candidate to hold in an IRA. Income from an MLP is not taxed at the corporate level, which avoids the common problem of double taxation for corporations. At tax time, the investor receives a K-1 schedule from the MLP stating the investor’s portion of the MLP’s net income. This MLP income is not tax-deferred if the units are held in an IRA. Holding this security in an IRA account eliminates the tax benefits of an MLP investment.

A downside of holding MLPs is that many of them invest in pipelines that run through several states. You may have to pay state income taxes, but some states offer exemptions.

What Are the Tax Benefits of Owning an MLP?

MLPs offer significant tax advantages because they are pass-through entities. This means that income generated by the MLP is only taxed at the investor’s level, not at the corporate level.

How Are MLP Distributions Taxed?

MLP distributions are not taxed when received. Instead, they reduce the investor’s cost basis in the MLP. When the investor sells the MLP units, any appreciation of the units is taxed as capital gains. If the cost basis reaches zero, distributions are taxed as capital gains.

Do I Need to Worry About State Taxes With MLPs?

Yes, MLPs that operate across multiple states may trigger state income taxes, depending on the location of the MLP’s operations. Some states offer exemptions, so it’s important to be aware of state tax rules when investing in MLPs.

The Bottom Line

Master Limited Partnerships can offer attractive tax advantages, making them a popular investment choice for those seeking income-generating assets. Because of how taxes are structured, MLPs are not suitable for all investment accounts, especially IRAs. It’s important for investors to understand the federal and state tax implications before investing in MLPs.