Master limited partnerships (MLPs) have stepped into the spotlight during the last decade, and today there are more than 115 issuers with a combined market capitalization exceeding $500 billion. Along with this growth in MLPs comes new tax terminology akin to alphabet soup. At the same time, there are a number of different MLP investment product structures with varying tax impacts—which can be especially daunting to investors new to the sector.
Our goal with this guide is to clarify some of the tax terms and explain potential tax ramifications for an MLP investor.
MLP Taxation 101: The Overview
MLPs are similar to corporations in some respects but are vastly different in others, especially with regard to tax treatment. Like individual taxpayers, a corporation must pay tax on its income. MLPs, on the other hand, do not pay tax at the entity level if they qualify as "publicly traded partnerships" by meeting special "qualifying income" requirements. "Qualifying income" is generated from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil or products), or marketing of minerals or natural resources.
Energy MLPs were given special tax treatment to encourage capital investment in domestic energy infrastructure. Most MLPs today are in energy, timber or real estate-related businesses.
As partnerships, MLPs are flow-through tax entities, with the obligation to pay taxes "flowing through" to the partners. From a tax perspective, as a limited partner in an MLP (also called a "unitholder"), you are responsible for paying your own share of the partnership's tax obligation.
You are allocated a share of the MLP's income, gains, losses and deductions based on your percentage ownership in the MLP. You report those numbers on your own tax return and pay any taxes due.
The amount of income and deductions (such as depreciation) allocated to you is based on several factors, including the timing of your investment, your purchase price and the degree of reinvestment by the MLP in its business. It is important to note that as a unitholder, your taxable income will include your share of the MLP's taxable income, regardless of whether you actually receive any cash distributions from the MLP.
Tax questions can arise soon after you purchase an MLP, so we will walk you through some of the common questions raised by new MLP investors.
The Ups and Downs of Tax Basis Accounting
When investing in MLPs, it is important to keep detailed records from the very beginning. This is because you will need to track the tax basis of your MLP investment from the time of purchase until the time you sell. It is helpful to keep comprehensive and up-to-date records of the items that impact your tax basis, because your tax basis is used to calculate your gain or loss upon the sale of an MLP.
Your initial tax basis simply reflects the value of your initial investment. As is the case with any investment, your initial tax basis is the starting point from which your future gains and losses on the investment are calculated.
But unlike other plain vanilla investments, it is what happens on a go-forward basis that can make MLP investing a bit more complicated. First, your tax basis is decreased by the amount of the cash distributions you received from the MLP. Next, your basis is increased by your share of an MLP's taxable income (or decreased by your share of an MLP's taxable losses).
The Ds: Distributions, Depreciation & Deferral
Although they resemble corporate dividends, MLP cash payments to unitholders are referred to as "distributions." Under their partnership agreements, MLPs generally are required to distribute the majority of their distributable cash flow to their unitholders. The levels of these distributions have historically been very attractive—currently averaging a little less than 6 percent of their current market price. MLPs typically pay quarterly distributions to their unitholders.
Cash distributions paid by an MLP to its unitholders are based on an MLP's cash flow, as generated by its underlying assets. As a result, cash distributions are typically not the same as (and are significantly larger than) the MLP's taxable income. This is because non-cash items, such as depreciation, are deducted from an MLP's taxable income.
This is also why it can be confusing at first blush to compare an MLP's income statement (which is reduced by non-cash depreciation) with its cash flow stream of distributions (which is not impacted by the non-cash depreciation).
As a MLP unitholder, your proportionate share of the partnership's depreciation expense is included in your share of the MLP's taxable income. The amount of depreciation expense allocated to you is determined by a variety of factors, including your purchase price. Additional depreciation from new investments in infrastructure by the MLP may also be generated.
The depreciation deduction essentially means that your overall tax bill may be deferred. The extent to which your MLP distribution is treated as deferred depends on your share of an MLP's taxable income. Because many MLPs have little or no taxable income, cash distributions in excess of taxable income received from an MLP are tax-deferred. These tax-deferred distributions are considered to be a "return of capital," because they reduce your tax basis in the MLP.
This tax-deferred characterization makes sense when you consider the assets that tend to be owned by an MLP. The underlying assets of an MLP (such as pipelines) are extremely long-lived, with minimal obsolesce risk and low maintenance expenditure requirements. Properly maintained, pipelines have a multi-decade lifespan—with the value of their "right-of-ways" arguably having a lifespan exceeding that.
However, for tax purposes, pipelines depreciate faster than they wear out (their economic usage). This resulting depreciation shield can provide an attractive tax deferral for an MLP investment, particularly in its early years.
The mechanics behind the tax deferral can be rather complex. You may be familiar with MLP lore that 80 percent of an MLP's distributions tend to be tax-deferred. This is an oversimplified assumption (and highly dependent on the timing of your investment and a particular MLP). In our experience, we have found the amount of tax deferral associated with an MLP investment to be variable, based on specific circumstances of each MLP, as well as the timing and price of the investment in an MLP.
Closing Your Books Upon MLP Sale
