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Making Sense of Master Limited Partnership Tax Rules

by Mary Lyman

So you’ve finally bought some shares in a master limited partnership (MLP) after hearing everyone rave about this equity investment that gives you a high yield, pays out cash every quarter and has tax advantages.

A couple of quarters go by, your investment pays off as promised, and you’re a happy camper. Then tax season rolls around and instead of the familiar Form 1099, a new form called a Schedule K-1 (Form 1065) shows up in the mail, with numerous boxes labeled with different types of income and deductions. What’s going on? What are you supposed to do with this?

The Basics

For those who are new to them, the first thing to understand is that an MLP is simply a publicly traded partnership (PTP). (Not all PTPs are MLPs, however; a number of PTPs are simply commodity pools.) By buying shares, technically referred to as “units,” in an MLP, you become a partner (or a “unitholder”) in this very large partnership. As a partner rather than a corporate shareholder, you enter a whole new world of taxation. Partnership taxation is what makes MLPs a tax-advantaged investment, but it also makes them more complex than many other investments.

As a partnership, an MLP is not considered to be a separate entity for tax purposes the way a corporation is, but rather is a pass-through entity—sort of an agglomeration of all its partners. An MLP does not pay corporate tax; instead, all the things that go into calculating tax—income, deductions, gain, losses and credits—are divided up among the unitholders as if they had earned the income themselves. Part III of the K-1 tells you your total share of each of these items.

You pay tax on your share of the partnership’s taxable income, as determined by all the items on the K-1. It is important to remember that you will owe tax on this income whether or not you receive a cash distribution.

Distributions Are Not Dividends

What about the distributions? Do you pay tax on them as well? You might think so, since the quarterly cash distributions look a lot like dividends; however, MLP distributions are not dividends, but quite a different creature. When you fill out your tax return, the only thing you have to worry about paying tax on is your share of net partnership income. The portion of the distribution that is equal to net income is covered by that tax payment.

Any distribution over and above the taxable income is considered to be a return of capital—you’re getting back some of the money you invested—and it is not taxed when you receive it. Rather, the distribution lowers the adjusted basis in your units. The lower basis increases the realized gain when you sell the units, and you pay more tax as a result; this is how the distributions ultimately get taxed. For the first few years that you hold the partnership unit, your taxable income will generally equal about 20% of your distribution, so you can consider that tax is deferred on 80% of the cash you receive. We’ll look more closely at adjusted basis later.

Another way that an MLP distribution differs from a corporate dividend is that the distribution per unit is often more than the net income. This is because MLPs don’t look at net income when they calculate their distributions; they look at distributable cash flow (DC)F. Distributable cash flow starts with net income, but adds back depreciation, because depreciation is an accounting entry that doesn’t actually affect cash flow. [Editor’s note: Depreciation is the amount of value an asset loses over time due to age and wear and tear.] Distributable cash flow also subtracts out the money that will be needed to keep capital assets in good working condition. There may be other adjustments as well. Most MLPs distribute most or all of their distributable cash flow.

  Amount per Share/Unit
  Corporation Publicly Traded
Partnership
 
Gross income $5.00 $5.00
Deductions ($3.00) ($3.00)
Net income $2.00 $2.00
Federal corporate tax (35%) ($0.70) $0.00
Aftertax net income $1.30 $2.00
Corporate dividend/partnership distribution* $1.30 $2.50
Shareholder’s federal tax on dividend (@15%) ($0.20)
Unitholder’s federal tax on share of net MLP income ($2.00 × 33%) $0.66
Net income to shareholder/unitholder $0.80 $1.34
     

Table 1 illustrates the differences between corporate shareholders and MLP unitholders using current (2012) federal tax rates. For simplification purposes, the chart assumes that the corporation pays out all of its aftertax income in dividends, which is, of course, very unlikely in real life.

Dealing With the K-1

Back to the Schedule K-1: What do you do with it? You can download your K-1 information from the MLP’s website and let a tax software program handle it for you. Or, you can hand the whole thing over to an accountant. Failing that, you will need to take the K-1 and insert each number reported in Part III of the form into the correct place on your own tax return—which often is the same place you would report it if you had earned the money yourself. The IRS’ Partner’s Instructions for Schedule K-1 (Form 1065), available at www.irs.gov/pub/irs-pdf/i1065sk1.pdf, will tell you where on your return each item goes; some information is also available on page 2 of the K-1. It is important to check with these instructions because some items, losses in particular, are handled differently for publicly traded partnerships than they are for other partnerships.

For the majority of MLPs, most of the income will be ordinary business income (Box 1), and will be reported on Schedule E of Form 1040. Interest and dividend income will be added to your own interest and dividend income on lines 8 and 9 of your 1040 (again—your distribution is not dividend income; this line is for your share of any dividends received by the MLP). Some items reported may be less simple, as they involve types of business income, deductions or credits that you are unlikely to have yourself, or they have special rules applying to MLPs. If you don’t have the particular forms for these, you can find them on the IRS’ Forms and Publications webpage, www.irs.gov/Forms-&-Pubs.

Passive Loss Rules

Passive loss rules are one area where MLPs are different from non-traded partnerships. These rules, section 469 of the tax code, categorize income and loss as “passive” when it comes from a partnership in which you are a passive investor rather than an active participant in the business. The general rule is that income and loss from different passive investments may be offset against each other, but passive losses may not be used to offset non-passive income, like your salary. Publicly traded partnerships (including MLPs), however, have a stricter rule: Losses from a PTP can be deducted only from income from the same partnership. Any excess losses must be carried forward to be used against income in future years; if there is not sufficient income, excess losses are held until you sell your entire interest in the partnership. Moreover, net income from a publicly traded partnership is not treated as passive income.

For this reason, the Partner’s Instructions for Schedule K-1 (page 4 of the 2011 version) tell you that rather than report passive income, gains and losses from a publicly traded partnership on Form 8582, the usual form for passive losses, you need to add up your share of income and gain items and subtract the deductions and losses. If the result is net income, the net amount (i.e., income minus loss) is not treated as passive income, but as investment income. The income and loss that offset each other are treated as passive and entered in the usual places on your return. If you have a net loss, the income and loss that offset each other are again treated as passive and entered in the usual places

Adjusted Basis

Another aspect of being an MLP unitholder is that it is very important to keep track of your adjusted basis in your MLP units. With an MLP, or any partnership investment, your adjusted basis changes every year. The adjusted basis determines not only your gain when you sell your units, but whether your distributions continue to be tax-deferred. Here is how it works:

  • Your initial basis is the price you paid for your units;
  • Distributions lower your basis;
  • Your share of partnership income reported on the K-1 each year adjusts the basis upward; and
  • Your share of deductions reported on the K-1 each year adjusts the basis downward.
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(Or more simply, net taxable income raises your basis and a net loss lowers it.)

Because distributions usually are more than K-1 income, it is likely that your adjusted basis will drop each year. However, your adjusted basis cannot go below zero. Once you reach zero, the portion of the distribution that was return of capital now becomes taxable—all your investment capital has been returned. Taxation of this portion of the distribution will occur at the capital gains rate.

Table 2 provides a very simple example of how it works.

Selling Your Units

As Table 2 shows, the calculation of your tax when you sell your units is also somewhat more complicated than with other investments. As discussed earlier, the difference between your adjusted basis at the time you sell your units and the price for which you sell them is your gain—but not all of that gain is taxed at capital gains rates. That is because with most MLPs, your taxable income each year is substantially lowered by depreciation deductions—that is why your taxable income is so low compared to distributions. As you know, if you have been involved in a real estate investment, the tax law requires that you “recapture” those depreciation deductions when you sell your investment by taxing that portion of the gain as ordinary income rather than capital gain.

Year 1: 1,000 units purchased @ $30.00. Basis is:   $30,000
Investor receives total cash distributions of $2.50 per unit   ($2,500)
Investor is allocated $2.00 of income on the K-1 2,000  
   and is allocated $1.50 of depreciation deductions, ($1,500)  
   for net income of $0.50 per unit. = $500
Adjusted basis: $30.00 – $2.00 = $28.00 per unit
$28,000
Year 2: All units sold @ $32.00 per unit
$32,000
Gain per unit: $32.00 – $28.00 = $4.00
$4,000
Depreciation recapture—taxed at ordinary income rates   $1,500
Amount taxed at capital gain rates   $2,500

In the Table 2 example, the unitholder had a $1,500 depreciation deduction. So $1,500 of the $4,000 is taxed as ordinary income and $2,500 as capital gain. As the years go by and you deduct more depreciation, the portion of gain that will be taxed as ordinary “recapture income” increases. However, this is mitigated to some extent by increases in the value of the units.

A point worth noting for estate planning: Like other securities, MLP units get a basis step-up to fair market value at the owner’s death. The heir inherits the units with a fresh fair market value basis, and the previous years’ distributions remain untaxed.

State Taxes

By now the question may have occurred to you: Does this pass-through system apply to state taxes, too? Yes, it does. Because you are treated as if you directly earned the partnership’s income, you may owe tax on your share of the MLP’s income in every state in which it operates.

The good news is that most MLP investors will not actually owe tax in states where they don’t reside. By the time an MLP’s income is allocated among all the states in which it operates and divided among tens of thousands of unitholders, the amount for one unitholder in any one state is likely to be very small, well below the threshold for owing tax. The master limited partnership will include in your K-1 package a list of your share of income in each state.

The bad news is that some states require you to file a return anyway. The Federation of Tax Administrators has a good website (www.taxadmin.org) with links to state tax information, including state tax rates, brackets and exemptions at www.taxadmin.org/fta/rate/ind_inc.pdf; and state tax forms and filing options at www.taxadmin.org/fta/link/default.php?lnk=2#.

MLPs and Retirement Accounts

Often investors would like to invest in MLPs through their individual retirement accounts (IRAs) or other qualified retirement accounts. MLPs can be held in these accounts, but there are some things you should consider before you do so. First, given that part of the benefit of an MLP investment is the tax deferral, you may not wish to “waste” this benefit on an account that is already tax-deferred.

More importantly, MLP investments held in an IRA or similar account are likely to be subject to “unrelated business income tax” (UBIT). UBIT is imposed on tax-exempt entities, including retirement plans, that earn “unrelated business income” (UBI)—income from a business that is not related to the purpose of their tax exemption. For instance, if a tax-exempt university operated a bowling alley off-campus that was not for the benefit of its students but simply a commercial enterprise, the income from the bowling alley would be UBI. This keeps the tax-exempt university from unfairly competing with taxable businesses, and also ensures that the income from operating this business gets taxed at least once.

Because MLPs are pass-through entities, tax-exempt unitholders (e.g., your IRA) are treated as directly “earning” the MLP’s business income and are taxed on it. Passive investment income such as interest, dividends and royalties are not considered UBI and will not be subject to UBIT if passed through to an IRA from an MLP.

The income subject to UBIT in an IRA is not the cash distributions. These are treated as return of capital in an IRA just as they are in a taxable account. It is the partnership’s business income, minus the deductions applying to that income, as reported on the K-1, which is subject to UBIT. In addition, the first $1,000 of UBI can be deducted, so only IRAs with net income over that amount will have to pay tax. The tax rate is the highest corporate rate, 35%.

Some analysts feel MLPs are a good investment for IRAs and other retirement funds despite the possibility of UBIT, because:

  • The pass-through of depreciation and other deductions means net income may be below $1,000. Many investors find that the UBIT reported for their IRA (which can be found in Box 20, code V of the K-1) is minimal or negative.
  • Even if tax is owed, the cash distributions may still be sufficient to produce a very good return.
  • Some important things to keep in mind:
  • The $1,000 deduction is per account, so you have a $1,000 deduction for each IRA you own. If you have more than one MLP or other UBI generator in a specific account, their income would be aggregated before subtracting the $1,000 in determining whether UBIT is owed.
  • If your IRA (or other account) does owe UBIT, the IRA, not you, owes the tax. The plan custodian should file a return and pay tax from the plan’s funds.

An alternative would be to invest your IRA in one of the many MLP funds now available. The number of these has grown considerably over the past few years, and several open-end and closed-end mutual funds, as well as exchange-traded funds (ETFs), are now available. You will lose some of the return to management fees and other costs, but the IRA will receive a dividend and avoid UBIT problems. These are also an option for individuals who want to avoid the K-1 and state tax hassles in their taxable accounts.

—Mary Lyman

Mary Lyman is executive director of the National Association of Publicly Traded Partnerships (NAPTP), a trade association of publicly traded (“master”) limited partnerships.


Discussion

Sebastian Lasher from VA posted over 2 years ago:

What tax software programs do you recommend to handle the K-1s?


Walter Wiatre from FL posted over 2 years ago:

Will Turbo Tax automatically compute the K1 information on my Tax return?


Gerald Lanois from FL posted over 2 years ago:

Comments above don't seem complete, re MLPS in IRAS.
What's missing, is taxation on sale of an MLP in an IRA.
Also, how tax is payed--ie who prepares the tax statement??
NAPTP is wholly incomplete on this issue.
Please publish the answers to above, for the benefit of the members??


Charles Rotblut from IL posted over 2 years ago:

Walter - Here is what Intuit says about Turbotax and the K-1: http://turbotax.intuit.com/support/iq/Investment-Income/Schedule-K-1-Information/GEN12344.html

Gerald - Capital gains realized in an IRA from a MLP are not taxed. As the article states, UBTI can be, if it exceeds a certain level.

-Charles


Joseph Steffan from NY posted over 2 years ago:

TurboTax does MLP K-1s easily, the cheapo programs either don't compute MLP K-1s or prove totally difficult to enter MLP K-1 info.


William Marley from VA posted over 2 years ago:

How does one handle MLP gains in a Roth IRA.


David Phillips from AL posted over 2 years ago:

I have been under the impression that for capital gains tax purposes, the original basis is used to calculate the gain or loss. There is of course recapture on the portion of income that was tax deferred. This is based upon the example in the old Wachovia MLP Primer.

Table 2 is the same info contained on the NAPTP web site and I would like to have this clarified please.


F paul Brady from CA posted over 2 years ago:

Yes, the K1's are not that difficult using Turbotax. One problem I found is that the information from the MLP often arrives very late so one has to wait until early April to finish putting the info into the forms.


Greg Mckelvey from GA posted over 2 years ago:

@F paul Brady: Good point. The deadline for issuing a K-1 is March 15th, unlike a W2 which is Jan 31st, for instance. It can be anxiety-producing if you aren't expecting it.

If you prepare your own tax return, I usually prepare it when I have all w2, 1099-x, etc. forms. I add the K-1 info as I receive them. Entering everything but the K-1 info early allows time for review and discovery of potential problems with enough time to correct them. [Like better planning of 1040-ES payments next year! :-) ]

If you have someone else dong the preparation, I would submit all information minus the K-1 forms as soon as I have it. That allows the preparer to enter the information and just complete the 1040 when the K-1 becomes available. That should result in a better quality (accurate) return, rather than delivering a whole sheaf of tax information during the CPA's "crazy season".


Gerald Lanois from FL posted over 2 years ago:

CHARLES,
THE FOLLOWING IS A RESPONSE FROM THE AUTHOR:


RE: My post about your recent article in Nov 2012 in AAII








Hide Details
FROM: mlyman@naptp.org
TO: gdlanois@yahoo.com

Message flagged

Thursday, November 1, 2012 5:40 PM







Thanks for your comment. I generally don’t get into the issue of taxation on the sale of an MLP in an IRA unless specifically asked, because it is not a completely settled issue (the IRS has never ruled on this question) and I am not a tax advisor. It is clear that the portion of gain from the sale that would be taxed at the capital gains rate in a capital account will not be taxable to the IRA. The question is, does the IRA have to pay tax on the recapture portion, the amount that is taxed as ordinary income in a sale from a taxable account? Of the MLP tax experts I’ve consulted—some tax lawyers, some accountants—some feel that there’s an argument to be made that the transaction would be completely tax free to the IRA. Others argue that there is only one interpretation, that because the tax code gives precedent to depreciation recapture over any other rule, the recapture amount is treated as unrelated business income and the IRA must pay tax on it. All agree that the IRS would take the latter position; the only question is which position would prevail in the Tax Court and any subsequent appeals. Again, I don’t give tax advice, but the safest route is probably to assume that recapture applies.



The article actually does indicate how the unrelated business income tax is paid (unless it was edited out; I haven’t seen the published version), as does the material on the subject on the NAPTP website: it is the responsibility of the plan’s custodian—for example, Fidelity if you hold your IRA in a Fidelity account—to file the appropriate tax return (Form 990-T) and pay the tax out of the IRA’s funds. Perhaps I should have emphasized this more, as there is a of lot confusion among investors about how affects their taxes. If you are the beneficiary of the IRA it has absolutely no effect on your taxes—the IRA itself is the taxpayer owing money to the IRS, and any tax payments come out of its funds not yours.



Feel free to post this reply


Robert Carr from NY posted over 2 years ago:

And folks wonder why we need a simplified tax code. Nice Job Mary.


Henry Absher from GA posted over 2 years ago:

I had been using TaxCut for years but it doesn't automatically handle the MLP K-1's. Switched to TurboTax several years ago and that works fine for me.


Herbert Edminster from KY posted over 2 years ago:

All of the discussion on MLP taxation appears to reinforce the conviction some people have that the USA is in need of a serious rework of our tax law patchwork. I assist elderly people with taxes, including some K-1's, through the AARP volunteer network and even people with modest incomes are overwhelmed by some tax considerations.


Bill Askwyth from FL posted over 2 years ago:

When dealing with multiple MLPs in an IRA (a Roth IRA) is the exemtion $1000 per MLP or $1000 for the entire IRA.


John Brennan from TX posted over 2 years ago:

It should be mentioned that there are at least three MLP based stocks that pay stock dividends or cash based on the parent MLP--KMR (KMP), EEQ (EEP), and LNCO (LINE). This means no K-1 and no tax hassels.


Dean Fisher from TX posted over 2 years ago:

When you sell your MLP does the company provide information on cumulative distributions and adjusted basis or do you have to go back to your K1's from each year of ownership and add it all up? I use Turbotax for my K1's, BTW.


Richard Sturgill from CA posted over 2 years ago:

I have been preparing my own taxes since 1991 using TurboTax and its prior versions. I started doing this because when I sent my tax info to my accountant it would be after April 1st each year and he would then request to file an extension in August. So, I got the same software he used and began preparing my own returns on time. He would then review my return and make any corrections if needed then he would file an amended return. I never needed to file an amended return so this has worked well. In a few years I stopped having my accountant review my return. After I file my return, I make a copy of the filed return and use it as a template to estimate the following year's return as the tax data changes such as; deleting the prior year's income, capital gains/losses and dividends then I enter the current year's income, capital gains/losses and dividends. I keep the same K-1 data and deductions from the prior year because it is nearly the same for the following year. When the following year's TurboTax software is released, I transfer all the information from the prior year's return and then use the template to enter the changed data and update the K-1s as they are released. Using this procedure I never have any tax surprises and I always know what my tax situation will be ahead of time.


Howard Winegarden from OR posted over 2 years ago:

One of my MLP's has come in real late (EPD). In order to expedite this, and avoid the hassle of a late report, I use the following website to get it on to the CPA:

www.taxpackagesupport.com


Howard Winegarden from OR posted over 2 years ago:

Having sold KMP, after 10 years, I found the recapture rather ominous. I thought that the reduction in tax base was the long term tax, and that was it. Now, my MLP investments will ride with me to the estate!


G Bruggeman from MA posted over 2 years ago:

Fabulous article. information that needs to be repeated every year or semi annually.
thanks


L Woolford from WY posted over 2 years ago:

Based on the above MLP article, I assume that holding a MLP in a Roth IRA avoids the need to process the K-1 through yearly federal and state tax filings.

I make this assumption based on the Roth IRA process that income is tax free as long as the rules are followed (ie after five years, withdrawals are tax free).

Comments/replies are invited.


John Callahan from CA posted about 1 year ago:

K-1 schedules Turbo Tax Business edition generates K-1's (1041) for estates, trusts.
MLP will generate K-1's ( 1065 ) , send them to unit holders in February, March following particular tax year in question. Hence, you need to specify in your question what type of K-1 are you referring? Thanks; john 1/15/2013


Charles Rotblut from IL posted about 1 year ago:

FYI.

A member asked if the unrelated business income tax rules also apply when a MLP is held in a Roth IRA. I checked with Mary about this and she said the rules apply, regardless if you are holding the MLP in a traditional or a Roth IRA.

-Charles


Wesley Davis from CA posted about 1 year ago:

turbotax should put out to all their
customers a detailed explanation of how
to handle tax accounting for MLPS from
purchase to completion of sale. that would
put them way ahead of other tax prep programs
and create many happy customers.


Wesley Davis from CA posted about 1 year ago:

turbotax should put out to all their
customers a detailed explanation of how
to handle tax accounting for MLPS from
purchase to completion of sale. that would
put them way ahead of other tax prep programs
and create many happy customers.


William Briggs from MD posted about 1 year ago:

Roth IRA question for MLP's was never answered until end of post and apparently it was answered by a customer. Strange. Maybe he's right, maybe wrong? Leaves one in limbo. Best and simplest was the MLP's that pay dividends or cash.KISS


Samuel Shepard from LA posted about 1 year ago:

Avoid all the tax mess. Invest in an ETF.
ALERIAN MLP ETF (SYMBOL, AMLP)
They invest in several MLP's and do all the tax work and distribute dividents just as a mutual fund does.


Lee Hausman from CA posted about 1 year ago:

Can someone summarize the pros and cons of holding a MLP in a Roth IRA? Thanks


Mike Harrington from NY posted about 1 year ago:

great story any ideas KMR IN IRA DID NOT KNOW THEIR WAS ETF IN MLP THANKS MIKEEEEEEEEEEEEEEE


Mike Harrington from NY posted about 1 year ago:

CAN I EMAIL THIS STORY TO MY SELY MIKEEEEEEEEEEEE


John Pellegrini from NY posted 11 months ago:

Your Table 2 simplified guide is wrong. The net income from the dividend is $1.30 minus $.20 equals $1.10 (not $.80). The K1 net income is $2.50 minus .33% tax or $.83 equals $1.10. Your math is bad. I hope your advise is better!


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