MLP Basics for Investors
What are MLPs?
MLPs (master limited partnerships) are publicly traded partnerships: limited partnerships which are traded on stock exchanges. A share in an MLP is called a “unit,” and owning MLP units makes you a limited partner. 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.
Why should I consider investing in MLPs?
In a time of insecurity in the stock markets, securities paying income can help mitigate the effect of fluctuating stock prices. MLPs are an income-oriented investment: their organizational mandate is to pay out all earnings not needed for current operations and maintenance of capital assets to their unitholders in the form of quarterly cash distributions. Many MLPs are also growth-oriented, striving to increase their distributions as often as is possible and prudent. In addition, MLPs are a tax-advantaged investment. As explained below, investors pay tax only on their proportionate share of the MLP’s income, which is greatly reduced by their share of deductions; distributions are tax-deferred. Finally most MLPs are in essential industries, providing energy and energy infrastructure, for which demand is likely to continue and increase.
What kinds of companies operate as MLPs?
Due to the requirements of the tax code, the great majority of MLPs—about 80 percent by number, representing close to90 percent of MLP market capital--are in energy-related businesses. The largest number of MLPs is in the midstream sector which gathers, processes, transports, and stores oil, natural gas, and refined petroleum products. There are also MLPs engaged in the production of oil and natural gas, distribution of propane and other refined products, coal leasing and mining, and marine transportation of petroleum products. In addition, there are some publicly traded partnerships in the investment industry and in various other businesses.
How are MLP units different from corporate stock?
The big difference is in how MLPs and their investors are taxed. Unlike corporations, MLPs and other partnerships are not considered as separate entities for tax purposes. Rather, MLPs and other partnerships are “pass-through” entities. No tax is paid at the partnership level; partnership income passes through and is taxed only at one level - that of the individual partner. Since deductions such as depreciation and depletion are also passed through to individual partners, taxable income is often quite low. Most MLPs make quarterly distributions to their partners that will significantly exceed any tax owed.
What does that mean for MLP investors?
Since the MLPs itself does not pay tax, it is able to pass along more of its earnings to its investors than a corporation. It does this in the form of quarterly cash distributions. From a tax standpoint these distributions are treated more favorably than corporate dividends. Rather than taxable investment income, the amount of distributrion beyond net income is considered to be a return of capital and reduces the partner’s basis in the partnership units. The partner will not be taxed on these amounts until the MLP units are sold and tax paid on the gain, including distributions, or when the basis reaches zero.
What happen when units are sold?
When the units are sold, the difference between the sales price and the adjusted basis equals the taxable gain (or loss). Some of the tax on the capital gain from selling the interest will be taxed at the capital gains rate. That portion of the gain that results from a downward adjustment of the basis after allocation of depreciation or depletion deductions will be taxed at the ordinary income rate.
What is a K-1? Will it delay my tax filing?
The K-1 form is the document an MLP investor will receive during tax season showing the investor’s share of each item of partnership income, gain, and loss, deductions, and credits. The K-1 provides the information necessary for an investor’s tax return. MLP investors receive this form instead of the 1099. While K-1’s cannot be made available in January as is done with the 1099, MLPs work hard to provide the K-1 on a timely basis. Usually an investor can download the K-1 from a company website in time to meet tax filing deadlines.
Can I hold MLPs in my IRA?
Yes, but MLPs may not represent the best investment for a retirement plan. First, an MLP offers significant tax benefits that are better utilized in a taxable account. Secondly, an IRA (or any tax-exempt entity earning income from an outside business) is subject to the “unrelated business income tax” (UBIT) after the first $1,000 of net income from a business that is unrelated to its exempt purpose (unrelated business taxable income, or UBTI). Since an MLP is a pass-through entity, the IRA would be considered to be “earning” the MLP’s business income, which is almost always considered to be unrelated to the IRA’s exempt purpose. If the IRA’s UBTI from all sources is over $1,000, the fund custodian will have to file a return and pay tax on the excess out of the IRA’s funds. Most advisors feel that unless there is reasonable certainty that the net income received from MLPs will be less than $1,000 each year, it is better not to hold them in an IRA. This is equally true of regular and Roth IRAs.
How can I or my retirement plan invest in MLPs without the tax hassle?
There are several closed-end mutual funds and a few open-end funds that concentrate on MLPs. If you invest through one of these funds, they will deal with the tax issues of being a limited partner and pass the income they receive from the MLPs on to you or your retirement account as a dividend, some of which will be treated as return of capital. You will receive a 1099 form instead of a K-1. The downside is that you will not get the full tax benefits of direct investment in an MLP, and some of the income will be retained by the fund for fees and expenses.
This fact sheet is for informational purposes only and should not be construed as offering tax or investment advice. Consult the appropriate advisor regarding your own situation.