Easy Street Investing

Tax day tips for MLP investors …

Nilus MattiveWhile I’m hardly an expert on taxes, I do insist on doing my own return every year. And since I specialize in income investments, I also field tons of tax-related questions on dividend stocks and other investments.

Perhaps no area of the income world generates more confusion than the special class of investments known as Master Limited Partnerships, or MLPs. So today I want to give you a quick rundown on MLPs, and raise a few of the biggest tax considerations involved with these investments.

As always, the standard disclaimers apply, including the fact that this column is certainly no substitute for a personal consultation with a tax professional who is familiar with your circumstances.

But with that said, let’s get started …

How a Master Limited Partnership
Differs from a Regular Corporation

The typical company is a plain old corporation, a separate legal entity from its employees and investors. They’re treated as separate legal entities come tax time, too. Thus, any money the corporation has left over after paying its taxes can be used for a range of purposes — R&D, acquisitions, dividends, etc. And when shareholders receive those dividends, they’ll eventually pay taxes on the income, too.

But as the name suggests, Master Limited Partnerships — also known as publicly traded partnerships — are organized as partnerships, which are not considered separate legal entities.

In other words, the partners are liable for the obligations of the partnership but also get all the direct benefits. (It’s worth noting here that your liability is generally limited, however.)

Only certain kinds of companies can qualify for this special status. At least 90 percent of the company’s income must come from certain sources such as interest, real estate rents, gains on commodities, and revenue from activities related to natural resources. This is why you’ll find a lot of MLPs that own timberland or oil pipelines.

And while they trade just like regular stocks on major exchanges, you’re technically buying “units” rather than “shares.”

Now, Here’s the Important Part Come Tax Time …
These Partnerships Are “Pass-Through” Entities!

As I said a moment ago, corporations pay taxes and then their shareholders who receive income pay taxes again.

Many MLPs operate oil and gas pipelines.
Many MLPs operate oil and gas pipelines.

In contrast, a partnership’s income is treated as if it is earned by the partners and it is allocated to them based on their individual stake. The partners also share in any other events that typically affect taxable income such as deductions and credits.

By law, MLPs are also required to pay out most of their cash flow to partners in the form of regular quarterly distributions.

These payments may look like plain ol’ dividends. However, there’s an important difference at tax time — the bulk of the quarterly distributions are considered a return of capital and not taxable investment income.

What does this mean? That much of your distributions are tax deferred — just as if they were in a 401(k) or traditional IRA plan!

What happens is that the cost basis of your partnership units — the price you originally paid — gets adjusted up and down for distributions, income, and those passed-through tax items. Let’s go through an example:

Step 1. You buy a unit for $10 that yields 10 percent. In other words, you’re receiving $1 a year.

Step 2. At tax time, the partnership will send you a form (called a K-1) that breaks down all your income, tax credits, etc. You are required to pay tax on this allocation at your individual tax rate. As a rough guideline, it might amount to 20 percent of your total distribution. Thus, you’d pay tax on $0.20 of the $1 distribution. If the partnership records a loss, you will carry this loss forward to next year to offset future income from the same MLP. You cannot use it to offset income from other sources.

Step 3. What about the other $.80 of income? That’s deferred. Uncle Sam figures your $10 partnership unit was reduced by the $1 distribution. He also says your unit was increased by the $0.20 you just paid tax on. End result: Your unit is now worth $9.20 in the eyes of the Tax Man.

Step 4. This process repeats itself every year until one of two things happens: A. You sell your unit or B. The value of your unit hits zero.

Step 5. Realistically, you’re better off holding for longer time periods, but let’s say you sell your unit after one year for $11. You will owe ordinary income tax on the $.80 of deferred income. And the $1 gain on the unit itself will be taxed at the capital gains rate.

That’s basically how it works. And as you can imagine, the ability to defer taxes on this income can be very advantageous depending on your particular situation.

However, There Are Also Two
Tax Disadvantages to Note!

The first one is counterintuitive — but you generally do NOT want to hold MLPs in tax-sheltered accounts like IRAs.

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It’s a long and boring story, but here’s the short version: Any amount of income that exceeds $1,000 will be taxable even if the MLP is held INSIDE a tax-sheltered account.

The reason is because it will be considered “unrelated business income.”

And importantly, the $1,000 limit is not applied to each individual holding but rather the income you might be receiving from all your MLPs.

Now, if you own just a small position in an MLP or two, this might not make a difference. Plus, you can also find certain MLP funds that will negate the risk of triggering the UBI tax.

But the safest route is simply holding your MLPs in taxable accounts.

Meanwhile, there is also a wrinkle when it comes to state taxes.

Reason: Many MLPs operate across a vast swath of the country and technically you could be earning income in many states each year.

Realistically, even if the individual states were looking at this you would have to own a substantial portion of units to come in above their income thresholds. Still, it is something else to be aware of.

Is it all a bit tricky? Yes.

But MLPs do their best to help investors wade through the process.

Plus, it is precisely these little hurdles that keep a lot people away from MLPs … leaving the juicy yields to those who are brave enough to sit down and get their hands a little dirty.

And considering the fact that some of my favorite MLPs are yielding 6 percent, 7 percent or even more right now … I certainly think the additional effort is worth it!

Best wishes,

Nilus

P.S. I’m currently recommending two MLPs to my Income Superstars subscribers right now. If you want to learn more about those companies — and all the other investments I like — just click here now.

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  • http://phaas55@yahoo.com patricia haas

    I already did my taxes 2012, I trade on my IRA, i just got kinder morgan parnters tax package and today another one for energy partners, what the hick do I do know? can you help me on this.
    past years I never had to do this kinda stuff. whay are we getting this now. thanks

  • Murat

    I own KMP for the first time, and am wonder if I have to file taxes in the nearly 35 states that KMP operates in. Just because you don’t owe any taxes, does it still mean you have to file?

  • Pat Pappano

    I buy units in an MLP for $10,000 and hold it long-term until I retire and the Cost-Basis is at zero. I now sell it and pay long-term capital gains tax on the proceeds, all of the proceeds because the Cost-Basis is zero. Sure I collected untaxed distributions that equal the difference between zero and what I bought it at, but I still wind up paying long-term capital gains tax on the original $10,000 which was already taxed when I received it as after-tax salary. Am I wrong? If not, better to own it, if at all, in an IRA.

  • Peter

    Great article. I was wondering about the implications of trading options on underlyings that shoot off K-1 forms. I suppose that as long as your are not “put” the underlying or have the underlying called away, you should not get the dreaded K-1 form.
    Will Nilus or any other knowledgeable person please confirm this?

    Secondly, what are the implications of a dividend/distribution payout (think ex-dividend date) by the underlying MLP or ETF entity while the trader has an open option position on the underlying – such as a short call?
    Thank you in advance for your input.

  • Bryan W

    Re MLP’s…..Can one avoid the K-1 process by simply paying the tax each year? At 78 I am not interested in deferring taxes. I want current year income. I would consider the Alerian fund but for the low dividend payout and relatively high expense ratio. I cannot seem to get an answer to this simple question.

  • gjperrin

    excellent,informative

  • John Johnson

    I have owned MLPs for years. Check on the MLP to see when they send their K1s. (All of mine do by early April.)

    I do my own taxes. I have used Turbo Tax for years. It does take a bit of a learning curve (what that is worthwhile doesn’t?) I’m not pushing TrTx. But, the Premier edition does a great job of handling K1s.

    Some of the MLPs also give out a good explanation of how you have to adjust your cost basis on a yearly basis to account for the return of capital part of MLP distributions. Set up a spread sheet once for each MLP and update it yearly.

  • Dave F

    Thanks for the heads up concerning the possibility of a tax liability from holding MLPs in tax – sheltered accounts, Nilus. I have shares of Energy Transfer Partners (ETP) in my Roth IRA and have had a feeling that I might somehow owe taxes on the regular quarterly dividends that I have been receiving. However, I could not find any information on the subject and the on line tax preparation software (Tax Act) I use did not ask about Schedule K-1 (Form 1065) entries. Fortunately, as shown on the company – provided Schedule K-1 Form, the unrelated business taxable income is negative so there was nothing to report. I will probably sell my shares to avoid a tax liability in the future, but I will have to do it carefully, with the aid of a tax advisor, to avoid incurring a UBTI. The Alerian Fund as mentioned above by jerry allen does indeed take care of the tax issues but consequently has a quite high expense ratio.

  • gary

    Nilus – what happens when a real estate MLP is lost by foreclosure:

    if the capital a/c is negative; if the capital a/c is still positive ??

  • phil r

    I own a number of MLP’s. The first one I bought 15 years ago EEP ( 400 shares)at approx $30/share. Stock is now at 60+. I’ve been getting dividends around 8% for all this time and have reinvested them. Based on my original cost I am getting more than 16% per year. Thats worth a bit of trouble in filing. I have a great tax preparer for the last 30 years.I would never consider filing on my own as you need help if you are ever audited. NEVER GO TO AN AUDIT ON YOUR OWN. I always file for extensions.I never file before Oct 15. So for me I don’t care about the late K1′s. My only regret was the market drop in 07 or 08, when EEP droped back in the high 20′s and I did not have the guts to buy more.They have never has never missed a dividend. When do you think they will stop pumping oil?
    I did like your article it was enlightening especially the part about the tax issues. Let the IRS figure it out as Mr Christe above said I agree with him.

  • ROSA

    I BOUGHT PMT AND DIDNT KNOW IT WILL GIVE ME A K1 FOR TAX. THANKS FOR EXPLAIN THE MLP STOCKS.

  • al christie

    Thanks for the great article on MLPs, Nilus. I have a small holding in SBR (Sabine Royalty Trust).
    The tax figuring looks even more complicated than an MLP! I do my own taxes, but I think I’ll just report the $119 income under “other” and let the IRS figure out the complexities of any other forms required, if they want to spend that much time on it! It’s way over my head. Wouldn’t it be great if we just had a flat tax, and everybody just paid 15%, period?

  • Bob R

    Kassenoff nailed it…MLP’s are way too much tax hassle for the average…or above average, small investor. I traded UNG 2 years ago and agonized over the resulting K1 despite using H&R Block tax software. Won’t touch another ever until I see a very reassuring review that shows an easy, inexpensive way to tame the tax beast. If I were an MLP issuer I”d get my trade association to put such a software solution in place that would complement/supplement popular tax software. Until they do, I’ll avoid them…the advantages are way outweighed by the drawbacks.

  • jerry allen

    dear nilus,
    nice article on mlp”s, I bought into alerian mlp index (amj) this last year. From what I understand this is a basket of mlp”s and they take care of tax issues in the fund.

  • Melvyn M. Kassenoff

    Nilus, drawbacks of MLP investments that you neglected to mention are: (1) Many MLPs distribute K-1s to unit holders as late as September which means that unit holders must obtain six month extensions of time to file their Federal and state income tax returns and must do preliminary Federal and state income tax returns prior to the April 15 deadline in order to know how much tax to pay with their applications for extensions of time. (2) MLP investments may complicate the Federal and state income tax returns of many investors. It will require them to file forms that they otherwise would not have to file and, unless like you and me they do their own tax returns, their tax preparer’s fee for preparing the tax returns will be significantly higher, possibly even exceeding their MLP distributions! For example, I own Brookfield Infrastructure Partners LP units; it is a Bermuda-based MLP whose operating headquarters are in Canada and whose investments are primarily in Australia and the UK. I have had to file Forms 8621 (as part of my Federal income tax returns) because some of Brookfield’s investments are structured as Passive Foreign Investment Companies (“PFICs”), make QEF (Qualified Elected Fund) elections and even learn the difference between a pedigreed QEF election and a non-pedigreed QEF election, all for sums under $10. Frankly, I have no idea as to whether I’m handling the matter correctly but I doubt that the IRS will challenge me for a couple of dollars. If you want to see my Brookfield K-1 and PFIC Statement, send me your E-mail address and I’ll send you my Brookfield tax packet (after deleting my S.S. number). (3) At times a unit holder’s Federal and state income tax liability can exceed the cash distribution received from the MLP.

    • Patrick Bryan

      Melvyn– please e mail your K-1 and PFIC return. I own CEF which is a PFIC but I’ve never reported it as such. Also own CQP which generates a K-1. Thx. pb

      • Melvyn M. Kassenoff

        Patrick-

        Send your E-mail address to me at melvyn.kassenoff@alum.MIT.edu and I’ll be happy to send you .pdf copies of various tax forms.

    • nova48

      Malvyn,
      I do own BIP and am struggling with filing the K-1 now. I’ll really appreciate if you can send me your tax package on BIP. THank you.