Master limited partnerships (MLPs) have stepped into the spotlight during the last decade, and today there are more than 115 issuers with a combined market capitalization exceeding $500 billion. Along with this growth in MLPs comes new tax terminology akin to alphabet soup. At the same time, there are a number of different MLP investment product structures with varying tax impacts—which can be especially daunting to investors new to the sector.
Our goal with this guide is to clarify some of the tax terms and explain potential tax ramifications for an MLP investor.
MLP Taxation 101: The Overview
MLPs are similar to corporations in some respects but are vastly different in others, especially with regard to tax treatment. Like individual taxpayers, a corporation must pay tax on its income. MLPs, on the other hand, do not pay tax at the entity level if they qualify as “publicly traded partnerships” by meeting special “qualifying income” requirements. “Qualifying income” is generated from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil or products), or marketing of minerals or natural resources.
Energy MLPs were given special tax treatment to encourage capital investment in domestic energy infrastructure. Most MLPs today are in energy, timber or real estate-related businesses.
As partnerships, MLPs are flow-through tax entities, with the obligation to pay taxes “flowing through” to the partners. From a tax perspective, as a limited partner in an MLP (also called a “unitholder”), you are responsible for paying your own share of the partnership’s tax obligation.
You are allocated a share of the MLP’s income, gains, losses and deductions based on your percentage ownership in the MLP. You report those numbers on your own tax return and pay any taxes due.
The amount of income and deductions (such as depreciation) allocated to you is based on several factors, including the timing of your investment, your purchase price and the degree of reinvestment by the MLP in its business. It is important to note that as a unitholder, your taxable income will include your share of the MLP’s taxable income, regardless of whether you actually receive any cash distributions from the MLP.
Tax questions can arise soon after you purchase an MLP, so we will walk you through some of the common questions raised by new MLP investors.
The Ups and Downs of Tax Basis Accounting
When investing in MLPs, it is important to keep detailed records from the very beginning. This is because you will need to track the tax basis of your MLP investment from the time of purchase until the time you sell. It is helpful to keep comprehensive and up-to-date records of the items that impact your tax basis, because your tax basis is used to calculate your gain or loss upon the sale of an MLP.
Your initial tax basis simply reflects the value of your initial investment. As is the case with any investment, your initial tax basis is the starting point from which your future gains and losses on the investment are calculated.
But unlike other plain vanilla investments, it is what happens on a go-forward basis that can make MLP investing a bit more complicated. First, your tax basis is decreased by the amount of the cash distributions you received from the MLP. Next, your basis is increased by your share of an MLP’s taxable income (or decreased by your share of an MLP’s taxable losses).
The Ds: Distributions, Depreciation & Deferral
Although they resemble corporate dividends, MLP cash payments to unitholders are referred to as “distributions.” Under their partnership agreements, MLPs generally are required to distribute the majority of their distributable cash flow to their unitholders. The levels of these distributions have historically been very attractive—currently averaging a little less than 6 percent of their current market price. MLPs typically pay quarterly distributions to their unitholders.
Cash distributions paid by an MLP to its unitholders are based on an MLP’s cash flow, as generated by its underlying assets. As a result, cash distributions are typically not the same as (and are significantly larger than) the MLP’s taxable income. This is because non-cash items, such as depreciation, are deducted from an MLP’s taxable income.
This is also why it can be confusing at first blush to compare an MLP’s income statement (which is reduced by non-cash depreciation) with its cash flow stream of distributions (which is not impacted by the non-cash depreciation).
As a MLP unitholder, your proportionate share of the partnership’s depreciation expense is included in your share of the MLP’s taxable income. The amount of depreciation expense allocated to you is determined by a variety of factors, including your purchase price. Additional depreciation from new investments in infrastructure by the MLP may also be generated.
The depreciation deduction essentially means that your overall tax bill may be deferred. The extent to which your MLP distribution is treated as deferred depends on your share of an MLP’s taxable income. Because many MLPs have little or no taxable income, cash distributions in excess of taxable income received from an MLP are tax-deferred. These tax-deferred distributions are considered to be a “return of capital,” because they reduce your tax basis in the MLP.
This tax-deferred characterization makes sense when you consider the assets that tend to be owned by an MLP. The underlying assets of an MLP (such as pipelines) are extremely long-lived, with minimal obsolesce risk and low maintenance expenditure requirements. Properly maintained, pipelines have a multi-decade lifespan—with the value of their “right-of-ways” arguably having a lifespan exceeding that.
However, for tax purposes, pipelines depreciate faster than they wear out (their economic usage). This resulting depreciation shield can provide an attractive tax deferral for an MLP investment, particularly in its early years.
The mechanics behind the tax deferral can be rather complex. You may be familiar with MLP lore that 80 percent of an MLP’s distributions tend to be tax-deferred. This is an oversimplified assumption (and highly dependent on the timing of your investment and a particular MLP). In our experience, we have found the amount of tax deferral associated with an MLP investment to be variable, based on specific circumstances of each MLP, as well as the timing and price of the investment in an MLP.
Closing Your Books Upon MLP Sale
When you sell an MLP, you will calculate your gain or loss, just as you would with any other investment. Your taxable gain is the difference between the sales price and your adjusted tax basis. However, this entire gain is not taxed at the same rate and must be split into two components.
First, the portion of your gain that is attributable to depreciation is taxed at ordinary income rates (called “recapture”). This information is provided in a supplemental sales schedule of the K-1 package (we look more closely at the K-1 in the next section). Think of the recapture portion this way—instead of paying applicable ordinary income rates when you received your cash distribution, you deferred some of the tax (due to the depreciation deductions passed through by the MLP). Therefore, upon sale, the government “recaptures” (and you pay) the tax that was deferred.
Second, the remainder of the gain (the difference between your sales price and tax basis minus the ordinary gain reflected on the K-1 sales schedule), is your capital gain and is taxed at the applicable capital gains tax rate, depending on holding period.
The Tax Package Itself: Understanding the Components
Partnership tax information is provided to you annually by the MLP on IRS Schedule K-1 (Form 1065) and in other important supplemental tax schedules. This information typically arrives in investor mailboxes between mid-February and early April. The K-1s are also available on MLP websites, accessible using your name and federal tax ID. Each separate MLP investment will generate its own K-1.
The good news is that qualified tax preparers should be familiar with MLP K-1s and should be able to accommodate them at some incremental cost. Personal tax preparation software also may accommodate K-1s. However, K-1s do add a layer of complexity to tax preparation, and at times, uncertain timing.
The first thing you should do upon receiving your tax documents is to confirm the number of units reflected in the supplemental schedule of your K-1. Accounting firms hired to prepare K-1s use the holding and transaction data provided by your custodian or brokerage firm. Occasionally, such data may be incomplete or incorrect and can result in errors. The potential for incorrect information is increased if you changed your custodian or account information during the year. Should any of the information not match your understanding, it is important to call the MLP’s tax line to get the information corrected.
Additionally, unitholders may be required to file separate state income tax returns in each state in which an MLP operates. Depending on the size of an investor’s MLP portfolio, MLP income attributable to states other than your state of residence could result in additional state income tax filing requirements.
What is in a K-1 Package?
Each K-1 package includes a Schedule K-1, an ownership schedule, a sales schedule and a state schedule.
Part I: Provides information about the partnership, including its address and if it is a publicly traded partnership (i.e. a master limited partnership).
Part II: Provides information about you as a limited partner. Be sure to carefully check this area to ensure it has your correct information.
Part III: Provides details regarding your share of income, deductions/credits and other items for the current year.
Ownership schedule: Your history of purchases and sales, and the dates and quantities of each, are listed here.
Sales schedule: If you had a taxable sale during the year, this schedule is used primarily to provide information regarding your ordinary gain (recapture). This schedule will be provided if you sold units during the year.
State schedule: This schedule lists all the states in which the MLP operates and the limited partner’s share of income (loss) attributed to such state. You may be required to file tax returns in these states. Your tax adviser should be able to assist you in understanding any state filing requirements.
A Schedule K-1 can be downloaded at http://www.irs.gov/pub/irs-pdf/f1065sk1.pdf.
We hope this information proves useful as you begin making preparations to pay Uncle Sam this year. While the tax terminology may appear challenging at first, it can be worthwhile to spend some time understanding the opportunity offered by MLPs or MLP funds and whether they are a good fit for your portfolio. MLPs have historically demonstrated investment characteristics that many investors view as attractive for their portfolios. Now that you understand some of the tax terms, you may surprise even your accountant with your knowledge of MLPs! If nothing else, you have a few new words to use in your next game of Scrabble or Words with Friends.
This article is redacted from its original form. Please contact Tortoise Capital Advisors at firstname.lastname@example.org for the full article.
Tortoise Capital Advisors does not provide tax advice. This information is for educational purposes only and is not intended to be, nor should it be construed as, tax advice or the basis of tax advice under any circumstances. Tax matters are very complicated, and the tax consequences of an investment in MLPs and MLP investment products will depend on the particular facts of each investor’s situation. Investors are advised to consult their own tax advisors with respect to the application to their own circumstances of the general federal income taxation rules and with respect to federal, state, local or foreign tax consequences.
This tax discussion is not intended to be used for the purpose of avoiding tax or penalties, and may not be relied upon by you to avoid penalties. This material is property of Tortoise Capital Advisors and may not be re-purposed for any reason without prior written consent. This publication is provided for educational information purposes only and shall not constitute an offer to sell or a solicitation to of an offer to buy any securities.