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.