A friend of mine recently had $5,000 he wanted to invest, and asked what I thought about Emerge Energy Services (NYSE: EMES). He wasn’t familiar with how master limited partnerships are structured, or with the tax implications of investing in an MLP. With the tax season upon us, many of you are dealing with these issues right now. Some of you may be considering your first MLP. But you need to be sure you understand the trade-offs associated with MLP investing.

The first MLP was formed by Apache Oil Company in 1981. In 1987 Congress legislated the rules for publicly traded partnerships in Internal Revenue Code Section 7704. The rules state that at least 90 percent of an MLP’s income must come from qualified sources, such as real estate or natural resources. Section 613 of the tax code requires qualifying energy sources to be depletable resources or their derivatives such as crude oil, petroleum products, natural gas and coal.

Recent case-by-case Internal Revenue Service rulings have expanded the range of activities qualifying for MLP treatment. The MLP Parity Act — which I discussed in Is MLP Parity Act a Game Changer? — would further expand the definition of “qualified” sources to projects involving wind and solar power, as well as closed and open loop biomass, geothermal, municipal solid waste, hydropower, marine, fuel cells, and combined heat and power.

MLPs and Taxes

An MLP issues units rather than shares, and MLPs aren’t taxed at the corporate level. MLPs pass profits directly to unitholders in the form of quarterly distributions. This arrangement avoids the double taxation of corporate income and dividends affecting traditional corporations and their shareholders and, all things being equal, should deliver more money to unitholders.

But the distributions aren’t fully taxed either. Because of the depreciation allowance, 80 to 90 percent of the distribution is considered a “return of capital” and thus not taxable when received. Instead, returns of capital reduce the cost basis of an investment in the MLP.

The rest of the distribution — typically 10 to 20 percent — is taxed at the recipient’s income tax rate. But being able to defer the rest of the tax until the investment is sold is an advantage, since the income can be reinvested to generate compound returns that could more than pay for the eventual tax bill.

When you ultimately sell the units or the cost basis drops to zero, a portion of the capital gain is taxed at the special long-term capital gains tax rate, and the remainder at your normal income tax rate.

MLPs issue Schedule K-1 forms instead of the 1099 forms you may receive from a corporation, and the K-1 will reflect your share of the taxable income. Partnerships are not required to report their results until the April 15 following the calendar year-end. Most K-1’s are issued between late February and early April, which could certainly delay a tax return. You may not have to file for an extension, but you also may not be able to file before March.

The other thing to understand about MLPs and taxes is that the K-1 package will include a state schedule. This schedule details the MLP’s share of income or loss attributed to each state in which it operates. For example, a pipeline may cut across 5 states and have reportable income in each state. You may be required to file state tax returns for each of these states, which means your tax reporting may be more complex and costlier, though most individual investors fall well under the threshold for having to do so .

Cost-Benefit Analysis

What all of this means is that you have to weigh the additional complications against the income you can expect to receive. Let’s consider the example of my friend’s $5,000. Emerge Energy Services is probably not a good MLP to use for this example, because its distribution and appreciation were highly atypical over the past year. Instead we will consider Enterprise Products Partners (NYSE: EPD), the largest publicly traded MLP and one more representative of the “typical” partnership.

Assume that my friend made this investment one year ago. Over the past year, EPD has yielded about 4 percent. So for an investment of $5,000, my friend would have received a total distribution of $200. As much as 90 percent of this could have been treated as a return of capital, leaving him with $20 of taxable income on his $5,000 investment. EPD also appreciated by 17 percent over the past year, which would have increased the size of his investment to $5,850. His cost basis would have been reduced to $4,820 (the initial $5,000 investment minus $180 of the distribution treated as a return of capital).

So my friend in this case would have been about $1,000 better off, but he now has to weigh that against tax complications. Further, that 17 percent appreciation is certainly not a sure thing, so he could end up with tax hassles over a mere $200 of income.

Alternatives Abound

Every person’s threshold is different, but $5,000 is definitely on the low side to invest in an MLP given the tax complications. If you are an investor seeking capital appreciation, I would instead invest in a corporation. If you have $5,000 and want exposure to an MLP structure, you can either invest in a mutual fund or an exchange traded fund (ETF) that invests in MLPs. See my recent article An Enticing Discount on MLPs for more information on these investments.

Or you could invest in an MLP that has chosen to be taxed like a corporation. I detail some of these options in Marshalling the Marines. In both cases you will receive a 1099 instead of a K-1, but you give up some of the tax advantages from the MLP structure. However you retain the potential to still benefit if you believe the MLP sector will strongly advance this year. These sorts of investments are also more suitable if you want MLP exposure within an Individual Retirement Account (IRA) or a 401(k) plan.

Conclusions

The MLP sector has grown dramatically over the past decade, and now garners attention from less-experienced investors. It is very important that those who are unfamiliar with the basics of MLPs take time to understand their tax implications. It is also important to understand that the value of an MLP — just like that of shares in a corporation — can fluctuate.

MLPs are most advantageous when held for long periods, because you get more time to compound the tax-deferred income. But make sure the income you do expect to receive is worth the trouble when it is time to pay your taxes.

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