Investors' Frequently Asked Questions
What are MLPs?
MLPs are publicly traded partnerships (PTPs): limited partnerships the interests in which, known as "units," are traded on public securities exchanges much like corporate stock. Buying MLP units makes you a limited partner in that MLP. Sometimes an MLP is technically not a partnership but a publicly traded limited liability company (LLC) which has chosen partnership taxation. There are some differences between the two, but for tax purposes they are the same. The term MLP generally is applied to PTPs that operate active businesses. There are a number of commodity fund PTPs that are simply investment funds and are not considered MLPs.What kinds of companies operate as MLPs?
Due to the requirements of the tax code, MLPs are predominantly in energy and natural resource related businesses. There are also MLPs There are also MLPs operating investment firms and a few other businesses. For more specific information on the regulation of MLPs, please see the Laws & Regulations section of the website.
How are MLP units different from corporate stock?
In some ways, they are very similar. They may be bought and sold on the New York, NASDAQ, and other public exchanges, and most of them pay a regular quarterly cash distribution. The big difference is that because MLPs are not corporations, they do not pay a corporate tax. Instead, all tax items pass through to the partners. This leaves more of the MLP's earnings free to pass on to you. Moreover, for most of the time you hold your MLP units, you will not have to pay tax on the distributions the way you do on corporate dividends. They are considered a tax-deferred "return of capital"-- that is, payback on your investment. They reduce the basis of your partnership units but are not taxed as current income.
On the other hand, you will be responsible for paying tax on your share of the partnership’s taxable income. However, most MLPs pay cash distributions that are well in excess of any tax owed.
If distributions are tax-deferred, is an MLP investment is tax-free until I sell it?
Not quite. As a limited partner, you will be allocated your proportionate share of the MLP's income and capital gain and will be responsible for paying tax on it. However, you will also be allocated a proportionate share of the MLP's deductions (such as depreciation), losses and credits. These will offset much, and in some cases all, of the income. All of these are allocated to you only on paper and are completely separate from the cash distribution.
So what does it mean when someone says that an MLP's distributions are, for example, "only 20% taxable?"
This is a shorthand way of telling you that your share of the MLP's net taxable income as reported to you each year on the K-1 form (see "tax time" question below) will be equal to about 20% of your cash distributions.
A net loss from an MLP is considered a "passive loss" under the tax code. Under the passive loss rules as they apply to MLPs, if you come out with a net loss for the tax year, you cannot deduct it from your taxable income from any other sources, even if it is passive income. However, you can carry it forward into future tax years and use it to reduce your taxable income from the same MLP. And if any of the loss is left over when you sell your MLP, you can deduct it from your other income in that year.
Can I use the income I'm allocated by an MLP to soak up some of my passive losses from other investments?
No. Passive income from an MLP may only be offset by passive losses from the same MLP, and passive losses from the MLP may not be offset against passive income from another investment. However, if the result of netting an MLP's passive income and loss is net income, it is then considered portfolio income, and other investment expenses may be deducted from it. Passive losses may be carried forward and used against the same MLP's income in future years. Any remaining loss may be used against other income when you dispose of your entire interest in the MLP
When do distributions become taxable?
You could pay tax on your distributions:
- If your adjusted basis in the units reaches zero. Your original basis is the price you paid for the units. It is adjusted downwards with each distribution and each allocation of deductions, and upwards with each allocation of income (don't worry about keeping track of all this--the MLP will do it for you).
- If you sell your units at a gain. Because the distributions have decreased your basis, they have increased the amount of taxable gain (which equals your sales price minus basis) on the sale. Some of your gain will be taxed at the lower capital gains rate, but the portion of the gain that results from deductions such as depreciation lowering your basis downwards will be "recaptured” by being taxed as ordinary income.
Do MLP units have a basis step-up at death like corporate stock?
Yes. The basis of MLP units received by inheritance will be the market value of the units on the date of death.
What do I do about my MLP investment at tax time?
Because you own a share of all the MLP's income and loss items, accounting for your MLP investment on your tax form is a bit more complex than accounting for corporate stock, but it's not as bad as many people fear. When the income tax filing season arrives, you will receive a schedule K-1 from the partnership. The K-1 will tell you your share of every kind of income and loss the MLP has. But the people who send you the K-1 won't just give you a bunch of numbers and expect you to know what to do with them. They will give you a complete package that will show you where everything goes on your tax return. In addition, for most MLPs an investor relations staff is just a phone call away if there is anything in the K-1 package that you don't understand.
Additional information can be found in the following two IRS publications by clicking on the links below:
Can I hold MLP units in my IRA?
Yes, but you should keep in mind some important limitations. Partnership income allocated to a tax-exempt organization or a trust like an IRA may be considered unrelated business taxable income (UBTI) subject to the unrelated business income tax (UBIT). However, it will not be taxed as long as the net UBTI for each partnership held by the IRA (gross UBTI minus the deductible costs of earning the income), when added to net UBTI for all other partnerships held by the IRA plus any other UBTI generated by the IRA's investments, does not exceed $1,000 in any year. Because IRAs are subject to the passive loss rules of section 469, investors cannot use a net loss from one MLP to offset net UBTI from the other MLPs or other investments in their IRS(see What if the income and deductions from the MLP come out to a net loss? above.
Note that it is the IRA's share of the partnership's income and not the cash distributions it receives that is subject to UBIT. You may decide that the MLP distributions are high enough that they still provide a favorable return on an after-tax basis.
If my IRA's MLP investment does generate UBTI exceeding $1,000 do I have to pay the tax?
You do not pay any tax yourself: the IRA is the unitholder and therefore is the taxpayer. The custodian of the IRA will be responsible for filing an IRS Form 990T. The IRA's share of all MLP income and of the deductions connected with the production of that income (as well as the income and deduction from any other partnership investments) is netted and entered on line 5, "Income (loss) from partnerships and S corporations." The "specific deduction" of $1,000 is entered on line 33. The deduction is subtracted from the amount on line 5, and tax is paid (out of the IRA funds) on the result, at the corporate tax rate. A statement showing the IRA's share of the partnership's gross income, and of the partnership deductions directly connected with producing the income, should be attached to the return.
Can I invest in MLPs through a mutual fund?
You can, but your choices may be limited, particularly for conventional mutual funds operating as Regulated Investment Companies (RICs) under the tax code. The American Jobs Creation Act of 2004 made it easier for mutual funds to invest in MLPs by adding them to the list of qualifying sources of income for RICs under the tax code, as long as MLPs do not constitute more than 25% of the RIC's assets. However, not many mutual funds have availed themselves of this opportunity, primarily because of concerns about timing issues in reporting taxable income.
However, there are several closed-end and open-end funds which invest primarily in MLPs, as well as MLP ETFs and ETNs. These funds can be found at the end of the list of currently trading MLPs. These funds can be found at the end of the list of currently trading MLPs.
How does MLP taxation work if I invest through a mutual fund?
The mutual fund will own the partnership units and becomes the limited partner. Like any partner, it is allocated a share of the MLP's income, is responsible for paying any owed on that income, and receives cash distributions. As an investor in the mutual fund, you will receive your share of the MLP income in the form of a dividend paid to you by the mutual fund. Note that for tax-exempt investors, this solves the UBIT problem, as dividends are not subject to UBIT. A portion of the dividend will be treated as return of capital; the fund will provide that information on the 1099.
Is it true that I have to pay tax in states in states where the MLP has operations?
As a partner in an MLP (or any other partnership), you are considered to be "earning" taxable income in any state where the MLP is earning income and are responsible for any state tax owed on that income. However, unless you hold a very large position in the MLP, there is a good chance that you will not owe tax and may not have to file. Once an MLP's net income is divided up among all the states in which it operates, and then is further divided among tens of thousands of investors, the amount of income allocable to any one investor for any one state will be very small. To assist you in determining whether you may have state tax obligations related to a particular MLP, this website provides a table showing the states in which each MLP operates and a link to information on each state's tax and filing thresholds.
How will the new 3.8% tax on “net investment income” that takes effect on January 1, 2013 affect me as an investor?The new tax will not affect you at all if your modified adjusted gross income (AGI) is below $200,000 (single filer) or $250,000 (joint filer). (Modified AGI is AGI adjusted for some provisions relating to income of U.S. citizens and residents living abroad). If your modified AGI is above those levels, your share of net partnership income (income minus deductions) as reported to you on the K-1 will be treated as “net investment income” for purposes of this tax. Your quarterly distributions are not “net investment income” but will continue to be treated as a tax-deferred return of capital until you sell your units (by contrast, corporate dividends will be subject to the new tax). When you sell your units, the resulting gain (including recapture amounts) is treated as net investment income.
The tax equals 3.8% times the lesser of 1) the difference between the taxpayer’s AGI and the threshold amounts, and 2) the taxpayer’s net investment income. For example, a single taxpayer with an AGI of $210,000 and net investment income of $25,000 would pay 3.8% x $10,000 = $380. Joint taxpayers with an AGI of $350,000 and net investment income of $60,000 would pay 3.8% x $60,000 = $2,280. Net investment income is reported on your Form 1040 and the tax is added to your normal income tax.
Please note that this FAQ is intended for general informational purposes only and is not intended as tax advice or investment advice. NAPTP is not a tax advisor nor an investment advisor and cannot provide you with such advice. Please consult the appropriate professional with regard to your own tax and investment situation.