Income Machines: Understanding MLPs
There is a wide variety of investments that look like stocks, but aren’t in fact stocks. Last week I examined American Depositary Receipts (ADRs). These are negotiable instruments that represent ownership in securities of a foreign company. ADRs facilitate U.S. trading of foreign securities, but they are not in fact conventional stocks.
This week I want to discuss another type of investment that looks like a stock, but isn’t: the master limited partnership (MLP).
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% 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, although subsequent case-by-case Internal Revenue Service rulings have expanded the range of activities qualifying for MLP treatment.
An MLP issues units rather than shares. The big advantage is that 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% 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%, 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 will be taxed 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 tax deadline following the calendar year-end. Most K-1s are issued between late February and early April, which could delay your tax return.
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.
MLPs fell out of favor in recent years following President Trump’s tax legislation. Among other things, the reduction in corporate income taxes reduced the tax advantages an MLP held over a corporation, and that resulted in an outflow of money from the MLP sector.
Direct MLP Alternatives
If you would rather not deal with the tax complications but you still want exposure to an MLP structure, there are available options. You could invest in an MLP that has chosen to be taxed like a corporation. These are mostly MLPs that have headquarters outside the U.S., and which are engaged in marine shipping. You will receive a 1099 instead of a K-1, but you give up some of the tax advantages from the MLP structure.
You can also invest in a mutual fund or an exchange traded fund (ETF) that invests in MLPs. These mutual funds must pay corporate income tax on their earnings, so again you will receive a 1099 for tax reporting. MLP mutual funds also lose some of the tax advantages, but gain diversification over individual MLPs.
Whereas individual MLPs may not be appropriate for tax-advantaged accounts like an Individual Retirement Account (IRA) or 401k because of the possibility of having to pay Unrelated Business Tax Income, an MLP mutual fund can be more suitable if you want MLP exposure within retirement accounts.
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