Written By: Michael Laitkep | Alerian
This week’s piece focuses on the taxation of individual MLP investments with the goal of clearing up common questions and misconceptions from investors, including: What is the MLP tax advantage? How are distributions taxed? What about MLP investment products? Given both the benefits and complexities of the MLP structure, understanding taxation is an important part of the investment story. As always, Alerian is not an accounting firm or tax consultant, and this piece does not constitute tax advice. For details specific to your situation and investment
, please consult your tax advisor.
Back to the basics: What is the MLP tax advantage?
To start off, let’s review what makes Master Limited Partnerships (MLPs) advantageous from a tax perspective. MLPs do not pay taxes at the entity level if 90% or more of their income is from qualifying sources
which are defined
in the Internal Revenue Code to include exploration and production, transportation, and other activities involving any mineral or natural resource. This benefit allows MLPs to return more of their cash flow to investors in the form of a distribution. Unlike a corporation, an MLP’s income, deductions, credits, and other items flow through proportionally to the unitholder as a limited partner. These items are detailed each year on a Schedule K-1 sent to the investor. The flow-through status of MLPs also holds on the state level, meaning MLP investors are required to pay state income taxes on their allocated portion of income in each state in which the MLP operates. It’s important to note that some states do not require you to file state tax returns unless your gross income exceeds a certain amount, which could reduce the number of required state filings. While K-1 forms result in extra work for investors (or their accountant), the pass-through benefit allows MLPs to avoid the double-taxation associated with investments in C-Corporations.
The passage of the Tax Cut and Jobs Act of 2017 maintained the tax advantage of the MLP structure but also brought some changes for MLP investors (Read More
). Importantly, an amendment to the bill allows
taxpayers to receive a deduction of 20% on qualified business income (QBI) from publicly traded pass-through partnerships, which includes MLPs. The deduction also applies
to 20% of income that is recaptured when units are sold. The amendment was designed to keep partnerships on competitive footing with C-Corps given the substantial reduction in the corporate tax rate. The tax reform bill also lowered the highest individual tax rate from 39.6% to 37%, which provides an additional benefit to MLP investors. Assuming a person receives the full 20% QBI deduction, the combined changes lower the effective tax rate
for an individual MLP investor in the highest tax bracket from 39.6% to 29.6%.
MLP distributions are largely tax deferred.
Investors who assume MLP distributions and C-Corp dividends have the same tax treatment may be surprised. Historically, 70-100% of MLP distributions have been considered
a tax-deferred return of capital. A high percentage of a distribution can be classified as a tax-deferred return of capital because the cash distributions received typically exceed the share of the partnership’s income allocated to the investor. The remaining percentage that is not considered a tax-deferred return of capital is taxed as ordinary income in the current year. For example, if 80% of a distribution is considered tax-deferred return of capital, then the remaining 20% will be taxed as ordinary income with the 20% QBI deduction mentioned above. The taxes on the 80% portion treated as return of capital will be deferred until the sale of the units if the investor’s adjusted cost basis remains above zero.
Understanding cost basis for MLPs.
An important concept in MLP taxation is cost basis, which is defined as the value of an asset for tax purposes. The purchase price of the MLP units is the initial cost basis of the investment. This cost basis is then adjusted upward by the proportional income from the partnership and adjusted downward by cash distributions and deductions like depreciation and amortization. As we mentioned above, cost basis matters for how the tax-deferred return of capital is treated. When your cost basis is above zero, the return of capital portion of distributions is tax deferred until the sale of the units. However, once an individual’s cost basis reaches zero, future distributions are treated as capital gains in the year they are received. The tax treatment of MLP units upon sale can be complex, so it’s important to keep track of your cost basis or make sure that your broker is accurately calculating your basis. At the time units are sold, the gain that results from basis reductions is taxed as ordinary income with a 20% income deduction, which is known as “recapture,” while the remaining amount is taxed as a capital gain. From an estate planning perspective, in the event of the death of a unitholder, the basis of the inherited units steps up to fair market value on the date of death. In case we have lost you with the accounting jargon, we have included an example below.