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Scaling K-1: Master Limited Partnerships and Taxes

By Peter Staas on January 14, 2011

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Master limited partnerships (MLP) have been around for almost three decades–Apache Oil Company, the first such partnership, launched in 1981–but these forbearers differed greatly from the modern-day incarnation. Though intended to facilitate investment in the energy industry, early MLPs gravitated toward exploration and production but also engaged in a wide range of other businesses.

By the end of 1986, there were 34 MLPs that operated outside the oil and gas industry, including offerings involved in restaurants, nursing homes, cable television and mortgage banking.

The modern MLP traces its roots back to the Tax Reform Act of 1986 and the Revenue Act of 1987, which required master limited partnerships to generate at least 90 percent of their income from “qualified” sources–many of which were related to natural resources.

Over the past year energy-focused MLPs have become more popular for the very same reasons as in the mid-1980s: high yields and tax advantages.

Yield chasers have long flocked to MLPs. An article in the March 19, 1987, edition of the Wall Street Journal noted that “in order to be competitive” an MLP needed to offer a 9 to 10 percent yield.

Today, MLPs are an attractive alternative to a frothy bond market, where spreads on high-yield issues appear insufficient to compensate for underlying risks.

And, as pass-through entities, MLPs don’t pay federal income taxes at the corporate level. They spread this responsibility among unitholders.

This tax relief is a huge advantage when these firms compete with traditional corporations for acquisitions. And investors avoid the double taxation to which corporate dividends are subject. (The government taxes corporation’s earnings as well as the dividend payments received by individual investors.)

But superior tax efficiency doesn’t necessarily translate into tax simplicity. A Schedule K-1typically arrives in late February or March and, like the familiar Form 1099, contains information that’s essential to determining your annual tax obligation. Here’s a brief overview of the tax treatment of MLPs.

Mastering Taxes

Individual investors must pay taxes on their share of the partnership’s income as though they generated it themselves. The amount of this paper allocation usually depends on the size of the holding. Because these calculations also factor in any losses, deductions or tax credits that the partnership experienced that year, unitholders are temporarily shielded from bearing the full brunt of the income tax burden. In many cases, these considerations are sizable enough to greatly reduce the amount of immediately taxable income. Once investors decide to sell their position in an MLP, however, they incur these deferred income taxes at the regular tax rate.

The other key component of the K-1 involves the quarterly cash distributions that partnerships disburse to unitholders. Varying in size based on the amount of distributable cash flow generated by the business, these payments are treated as a return of capital that reduces the investors’ original cost basis.

That is, most distributions aren’t taxed when received. Instead, these annualized payouts (along with any deductions) are subtracted from the initial cost of investment, while any income tax paid is added to this figure. When your K-1 indicates that this adjusted cost basis has reached zero, the distributions become taxable at your full income tax rate.

At the same time, because distributions decrease the adjusted basis, they necessarily increase taxable gains that you would incur in the event you sell your MLP units. For example, the difference between the stock sale price and the original basis price would be taxed as long-term capital gains, whereas the difference between the original basis price and adjusted basis price would be taxed at the full income tax rate.

It bears noting that the basis resets to the current market price in the event that the unitholder dies, making these securities an attractive option for estate planning.

This is an undoubtedly convoluted process, and the complexity multiplies when you own several MLP stocks. To reduce headaches when tax season rolls around, we recommend that investors consult with a tax professional.

Also keep in mind the substantial tax benefits that MLP holdings offer: Unitholders typically end up paying annual income tax that represents only 10 to 15 percent of distributed cash. The remainder is deferred until the security is sold, allowing investors to put that money to work in other investments.

MLPs and IRAs: Bad Idea

Although you can technically hold MLP units in an IRA and other tax-exempt investment vehicles, don’t do it.

Placing investments that are already tax-advantaged in a tax-sheltered account isn’t the most efficient allocation of resources; hold MLP units in brokerage accounts and keep your IRAs and 401(k) plans for more traditional fare.

 And there’s an even more compelling reason not to put MLP units in IRA accounts: The Internal Revenue Service (IRS) classifies some income generated by PTPs held in IRAs as unrelated business taxable income (UBTI). That means if total income–not the distributions–associated with one or more MLPs exceeds $1,000, the plan administrator will be forced to file a return and pay an unrelated business income tax (UBIT) from available funds.

Investors interested in the attractive yields and returns offered by MLPs, but leery of navigating the tax complexities might consider a closed-end fund that specializes in these securities. Not only do the fund managers deal with the vagaries of the K-1 and cost basis adjustments–investors receive Form 1099–but income from these funds is exempt from UBIT.

MLP Masters

Looking for more information on MLPs? Elliott Gue and Roger Conrad’s MLP Profits advisory includes proprietary ratings of every publicly-traded partnerships as well as model Portfolios for aggressive and conservative investors and detailed analysis of the latest developments and trends. Click here to register for a no-risk free trial of the service.

Upcoming Appearance

Ellliott Gue, editor of The Energy Letter and The Energy Strategist, will share his take on the global energy markets and related investment opportunities on Jan. 21 at Pastiche Modern Eatery in Tucson, Ariz. The event is hosted by the Tucson Society of the CFA Institute and will get underway 11:45 am. Admission is $30 for nonmembers and $20 for members. For more information on this event and how to RSVP, click here.

Come Sail Away

Also join Elliott Gue aboard Holland America Lines’ ms Eurodam for the 2011 Money Answers Cruise. Departing from Fort Lauderdale on Feb. 12, 2011, for a week-long tour of the Caribbean, my guests will enjoy a week of unparalleled luxury as well as unfettered access to some of the world’s top investing minds.

For more details on this unique opportunity to recharge your batteries and investment portfolio, go to www.MoneyAnswersCruise.com or call 1-800-707-1634.

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