How to Benefit From MLPs’ Complex Tax Rules

Investors have options when buying and selling master limited partnerships, a Morningstar expert explains

Master limited partnerships are attractive total-return vehicles for investors, but their tax treatment can be intimidating.

ThinkAdvisor spoke with Abby Woodham, a fund analyst with Morningstar’s Passive Fund Research group in Chicago, about what issues investors should keep in mind when mulling MLP purchases and sales.

Can you briefly summarize the rather complex issue of MLP taxation?

Individual MLPs, which are partnerships and are not seen as separate from their owners, pass their tax liability onto unitholders, so you—the investor—would owe taxes on your portion of an MLP’s taxable income, which is stated on a K-1 tax form.

If your MLP investment generates high enough income in a state other than your own, you could have to file a tax return in that state. Luckily, some states (Texas, for instance) do not levy a state income tax.

This can be a bit of a pain for some people.

Can you explain what makes MLP taxation complicated?

The distributions you receive are treated as return of capital, and reduce your cost basis. You only pay tax on these distributions when you sell your MLPs units. This is effectively tax-differed distribution. Plus, you only pay taxes on the taxable part of a distribution, which often can be zero.

MLPs can use depreciation to reduce their reported net income lower than the level of cash they are distributing to unitholders.

If, for example, you had $100 of shares and sold them for $105 at the end of the year. The MLP paid you a $5 distribution, but only $1 is taxable income because of depreciation. The remaining $4 is treated as return of capital. You are not liable for a tax on it today, but it gets deducted from your cost basis. So, you owe taxes on the $1 at your ordinary income rate.

If you hold the MLPs, you would just pay your ordinary income tax rate on the $1 and wait to pay any tax on the $4. When you finally sell your shares, you pay your ordinary income rate on the $4 because it’s recapture of past depreciation deductions. You get the benefit of tax deferment. As the years go on, it can be attractive.

On the flipside, if you own an MLP for just a year, you’re paying the ordinary rate on your distributions. That’s less attractive that the rate you’d pay on qualified dividend income from stocks.

The longer you own an MLP, the more tax deferment becomes an attractive proposition.

How else can investors hold MLPs?

Exchange-traded notes’ taxation is fairly straightforward. The ETN does not hold any securities, but pays out the return of the index less fees, so you get a distribution as if you owned the securities. Again, there is no MLP ownership, so the distribution is taxed at the ordinary income rate. If you sell the ETN shares, you’ll pay capital gains tax on any price appreciation.

It’s straightforward, but there is no tax deferred distribution. For those looking for this deferment, ETNs may not be best.

ETFs are more complicated, since ETFs hold the securities in an index. They have actual MLP ownership, and most have to be structured as C corporations—like the Alerian MLP ETF (AMLP).

The “bummer” part is that the ETF must accrue for the future tax liability of unrealized gains in its portfolio. That amount is deducted from the fund’s NAV daily.

This means a typical investor has to give up 37-38% of total return to the accrued deferred corporate income tax liability. Investors receive a 1099, not a K-1. The fund company handles the K-1s.

As of late January, AMLP was up 11% vs. the 18% for the index. The gap reflects the corporate tax liability, which is a function of its structure. That’s a big bite out of your performance, especially when MLPs are going great.

There’s a new second-generation of MLP ETFs, which are made of MLPs (25%) and MLP affiliates and related utilities (75%). This concept is interesting but young, so it’s hard to say much about its tax implications yet.

What’s the best way to compare these investments?

Owning MLPs can be a bit of a nightmare, since there is no perfect way to own them, but investors do have a few options--ETNs, ETF, closed-end funds and straight-up ownership of individual MLPs.

The general rule is that if you are interested in total returns but don’t need the tax deferral on distributions, look at ETNs. If you’re only interested in income and not price returns, then it might be worth looking at ETFs for their tax treatment of distributions. If you only own a handful of individual MLPs, it’s easier to file a K-1 than in the past. For example, you can report the K-1 information using TurboTax.

Also, you could own five or 10 MLPs like an index does, if you’re not bothered by the K-1.

It all depends on the individual investor.

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Related ThinkAdvisor story: 8 Costly Tax Blunders to Avoid in 1031 Exchanges

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