From the February 2014 issue of Research Magazine • Subscribe!

MLPs: Facts for Advisors, Clients

Why should investors consider MLPs? Securities paying income can help mitigate the effect of fluctuating stock prices. MLPs are an income-oriented investment; their organizational mandate is to pay out all earnings not needed for current operations and maintenance of capital assets to their unitholders in the form of quarterly cash distributions.

Many MLPs are also growth-oriented, striving to increase their distributions as often as is possible and prudent. In addition, MLPs are a tax-advantaged investment.

As explained below, investors pay tax only on their proportionate share of the MLP's income, which is greatly reduced by their share of deductions; distributions are tax-deferred. Finally, most MLPs are in essential industries, providing energy and energy infrastructure, for which demand is likely to continue and increase.

What kinds of companies operate as MLPs? Due to the requirements of the tax code, the great majority of MLPs—about 80% by number, representing close to 90% of MLP market capital—are in energy-related businesses. The largest number of MLPs is in the midstream sector, which gathers, processes, transports and stores oil, natural gas and refined petroleum products.

How are MLP units different from corporate stock? The big difference is in how MLPs and their investors are taxed. Unlike corporations, MLPs and other partnerships are not considered as separate entities for tax purposes. Rather, MLPs and other partnerships are "pass-through" entities.

No tax is paid at the partnership level; partnership income passes through and is taxed only at one level—that of the individual partner. Since deductions such as depreciation and depletion are also passed through to individual partners, taxable income is often quite low. Most MLPs make quarterly distributions to their partners that will significantly exceed any tax owed.

What does that mean for MLP investors? Since the MLPs itself does not pay tax, it is able to pass along more of its earnings to its investors than a corporation. It does this in the form of quarterly cash distributions. From a tax standpoint, these distributions are treated more favorably than corporate dividends.

Rather than taxable investment income, the amount of distribution beyond net income is considered to be a return of capital and reduces the partner's basis in the partnership units. The partner will not be taxed on these amounts until the MLP units are sold and tax is paid on the gain, including distributions, or when the basis reaches zero.

What happen when units are sold? When the units are sold, the difference between the sales price and the adjusted basis equals the taxable gain (or loss). Some of the tax on the capital gain from selling the interest will be taxed at the capital gains rate. That portion of the gain that results from a downward adjustment of the basis after allocation of depreciation or depletion deductions will be taxed at the ordinary income rate.

What is a K-1? How does it impact an investor's tax filing? The K-1 form is the document an MLP investor will receive during tax season showing the investor's share of each item of partnership income, gain/ loss, deductions and credits. The K-1 provides the information necessary for an investor's tax return.

MLP investors receive this form instead of the 1099. While K-1s cannot be made available in January as is done with the 1099, MLPs work hard to provide the K-1 on a timely basis. Usually an investor can download the K-1 from a company website in time to meet tax filing deadlines. Can investors hold MLPs in an IRA? Yes, but MLPs may not represent the best investment for a retirement plan. First, an MLP offers significant tax benefits that are better utilized in a taxable account. Secondly, an IRA (or any tax-exempt entity earning income from an outside business) is subject to the unrelated business income tax (UBIT) after the first $1,000 of net income from a business that is unrelated to its exempt purpose (unrelated business taxable income, or UBTI).

What other options do investors have? There are several closed-end mutual funds and a few open-end funds that concentrate on MLPs. If investors turn to one of these funds, they will receive a 1099 form instead of a K-1.

Source: National Association of Publicly Traded Partnerships

Reprints Discuss this story
This is where the comments go.