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MLPs, Taxes, the K-1 & More: Frequently Asked Questions

How are MLPs structured?

MLPs have two classes of ownership, which are general partners (GPs) and limited partners (LPs). GPs manage the partnership’s operations, receive incentive distribution rights (IDRs), and generally maintain a 2% economic stake in the partnership. LPs are not involved in the operations of the partnership and have limited liability, much like the shareholder of a publicly traded corporation.

How is an MLP different than a C corporation?

Unlike regular corporations, MLPs do not pay corporate-level tax. They pass through the majority of their income (and deductions) to the holders of their limited partnership.

Whereas investors that own shares in a corporation are considered shareholders, MLP investors are considered unitholders that own interests (or units) in the MLP. Since the MLP itself does not pay corporate-level tax, the income, deductions, and tax attributes from the MLP are passed through to their limited partnership unitholders. Instead of receiving a Form 1099 detailing cash distributions paid, an MLP investor is responsible for filing a partnership tax information return known as a Schedule K-1.

What are incentive distribution rights (IDRs)?

IDRs provide GPs with the necessary incentive to grow the MLPs’ distributions and consequently raise the GPs’ quarterly cash distributions. The partnership agreement entitles GPs to receive a higher percentage of incremental cash distributions when the distribution to LP unitholders reaches certain tier levels.

What are the tax advantages of owning MLPs?

A unitholder’s basis is adjusted upward by the amount of partnership income allocated and adjusted downward by the amount of cash distributions received. For most MLPs, cash distributions received exceeds the allocated income. The difference between the cash distribution and allocated income will be treated as “return of capital” to the unitholder and reduces the unitholder’s basis in the units. Typically, 70-100% of MLP distributions are tax-deferred, with the remaining portion taxed at ordinary income rates in the current year.

As long as the investor’s adjusted basis remains above zero, taxes on the return of capital portion of the distribution are deferred until sale of units. If an investor’s basis reaches zero, then future cash distributions will be taxed as capital gains in the current year. Upon sale of the MLP, the gain resulting from basis reductions is recaptured and taxed at ordinary income rates and any remaining taxable gain is taxed at capital gain rates for investments held greater than one year.

From an estate planning perspective, if units are passed along to heirs, upon death of the unitholder, the basis is “stepped-up” to the fair market value of units on the date of death and prior distributions are not taxed.

Are MLP distributions guaranteed? Is there a minimum amount of distributions that must be paid?

MLP cash distributions are not guaranteed and depend on each partnership’s ability to generate adequate cash flow. Unlike Real Estate Investment Trusts (REITs) that must distribute a certain percentage of their cash flow, each MLP’s partnership agreement determines how cash distributions will be made to general partners and limited partners. Generally speaking, partnership agreements mandate that the MLP to distribute 100% of its distributable cash flow (DCF) to unitholders within 45 days after the end of a quarter. The general partner has discretion to retain or reserve a portion of distributable cash flow within the partnership.

Can MLPs be held in an IRA?

MLPs can be held directly in an IRA. However, partnership income – not cash distributions – may be considered unrelated business taxable income (UBTI) subject to unrelated business income tax (UBIT) if UBIT exceeds $1,000 in a year. The custodian of the IRA will be responsible for filing an IRS Form 990T and paying the taxes. More information can be found in the IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations or in the Internal Revenue Code, Section 512: Unrelated Business Taxable Income.

Does an MLP unitholder have to pay state taxes in every state where the MLP operates?

Yes. An MLP unitholder is responsible for paying state income taxes on the portion of income allocated to the unitholder for each individual state. In most cases, however, unless the unitholder owns a large position, the share of allocable income is typically small and the unitholder may not have to file in certain states due to minimum income limits. Additionally, some states in which MLPs operate do not have state income taxes, such as Texas and Wyoming.

Is there a way to gain exposure to MLPs but avoid filing K-1s and state taxes?

There are several publicly traded pooled investment products that handle the K-1s and state tax filings for the investor, and in return, distribute a Form 1099 to investors. Passively managed MLP products that track indices include exchange traded funds and exchange traded notes. A list of products that track the Alerian MLP index series can be found at www.alerian.com. Actively managed MLP products include MLP mutual funds or closed-end funds.

Can MLPs be used as an estate tax planning tool?

Yes. Upon death, the cost basis of a unitholder’s MLP investment is reset (stepped-up) to the price of the units on the date of transfer, thereby eliminating a taxable liability associated with the reduction in the original unitholder’s cost basis. As always, investors should consult a tax or estate planning tax professional for advice.

Where can I find more information on MLPs?

The National Association of Publically Traded Partnerships (www. naptp.org) is the lobbying organization for MLPs. Their website includes several primers from sell-side research analysts and buy-side institutions. Similar to Alerian, the NAPTP does not provide investment research on specific MLPs.

What is the difference between an MLP exchange traded fund (ETF) and exchange traded note (ETN)?

An ETN and ETF are both passively-managed options designed to track the performance of an underlying index. Some, but not all, of the differences between them are listed below.

IRA/401k Eligibility. The ETF is IRA and 401(k) eligible and does not generate unrelated business taxable income (UBTI). The ETN can be invested in IRAs and 401(k)s; however, no should-tax opinion (or official stance) has been obtained from a tax counsel by any of the current ETN issuers, meaning IRA and 401(k) eligibility has neither been confirmed nor denied.

Credit Risk. An ETN is a senior unsecured obligation of the issuing bank, thereby exposing the investor to credit risk. Although the maturity of the available MLP ETNs is currently over ten years, credit exposure is limited to a one-week rolling basis. The minimum repurchase amount is 50,000 notes and the repurchases are available on a weekly basis. The ETF does not carry the credit risk of the product issuer, but similar to any equity investment, the ETF does carry the credit risk of the underlying companies.

Corporate Taxes and “Tracking Error.” Unlike a typical equity or bond mutual fund, which is treated as a Regulated Investment Company (RIC) for tax purposes, an MLP ETF is taxed as a C corporation. Equity and bond mutual funds are allowed to make the RIC election because the securities in which they invest (stocks and bonds) are taxable entities. Because MLPs themselves have no entity-level tax, the IRS requires any open-ended or closed-ended fund that invests more than 25% of its assets in MLPs to be taxed as a C corporation.

As a result, an MLP ETF must accrue deferred income taxes for any future tax liability associated with (1) the portion of MLP distributions from underlying securities considered to be a tax-deferred return of capital and (2) capital appreciation or depreciation of the underlying securities. The net asset value (NAV) of the fund will be reduced (or enhanced) by this.

What is the likelihood that Congress would abolish the preferential tax treatment afforded to MLPs?

Most MLP industry analysts view a change in MLP tax status as unlikely, as MLPs are an integral part of domestic energy infrastructure. Moreover, MLPs have already experienced tax reform. In 1987, Congress created Section 7704 in the tax code to define and limit publicly traded partnerships to those with specific qualified income sources, mitigating the probability that something similar to Halloween 2006 for Canadian Income Trusts will occur. On January 17, 2012, the staff of the Congressional Joint Committee on Taxation (JCT) released its annual list of tax expenditures. For energy and natural resource publicly traded partnerships, the total revenue loss over five years (2011-2015) is estimated to be $1.5 billion, equating to roughly $300 million per year. This amount, if collected, would likely have a de minimis impact on the trillion plus dollar U.S. deficit.

Source: Alerian, 3/31/2012

 

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