Master Limited Partnerships

March 13, 2024

7769 / What income requirements must a master limited partnership (MLP) satisfy?

<div class="Section1"> MLPs were not common real estate investment vehicles until Congress reduced individual tax rates below corporate tax rates pursuant to the Tax Reform Act of 1986 (TRA ’86).<a href="#_ftn1" name="_ftnref1">1</a> TRA ’86 lowered the individual tax rate from 50 percent to 28 percent, and the corporate tax rate was reduced from 46 percent to 34 percent (the highest individual income tax bracket is currently 37 percent and the highest corporate tax rate is 21 percent).<a href="#_ftn2" name="_ftnref2">2</a> The following year, to counter the threat of revenue erosion, Congress added IRC Section 7704 that provides that a publicly traded partnership will be taxed as a corporation unless the partnership meets certain gross income requirements.<a href="#_ftn3" name="_ftnref3">3</a> A partnership satisfies the gross income requirements of IRC Section 7704 when at least 90 percent of the partnership’s gross income is “qualified income.”<a href="#_ftn4" name="_ftnref4">4</a> Some forms of qualified income include interest, dividends, real property rents, income and gains derived from the exploration, development, mining or production, processing, refining, transportation (pipelines, ships, trucks), or the marketing of any mineral or natural resource.<a href="#_ftn5" name="_ftnref5">5</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. See Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-87) May 4, 1987. <a href="#_ftnref2" name="_ftn2">2</a>. Pub. Law No. 115-97 (the 2017 tax reform legislation). <a href="#_ftnref3" name="_ftn3">3</a>. IRC §§ 7704(a), (c)(1). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 7704(c)(2). <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 7704(d)(1). </div></div>

March 13, 2024

7770 / What distribution requirements must a master limited partnership (MLP) satisfy?

<div class="Section1">In general, MLPs attract investors by contractually agreeing to distribute quarterly all available cash. However, the “all available” cash provision is normally limited by the general partner’s (GP) discretion to hold a reserve required to carry on the MLP’s business operations. As further investor enticement, the MLP agreement generally establishes a subordination period for the sponsor’s limited partner interest that allows for sufficient cash flow to be distributed so that common units receive minimum distribution levels.</div>

March 13, 2024

7772 / Can a tax-exempt organization that would become subject to the unrelated business income tax because of its investment in a master limited partnership (MLP) avoid this tax?

<div class="Section1"> Tax-exempt organizations can avoid the UBIT issue Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7771">7771</a> by indirectly investing in MLPs through the use of what is known as a “UBIT blocker.” In order to “block” the UBIT, the tax-exempt organization invests in a corporation that owns units in a MLP. The corporation distributes any income received from the MLP as dividends to its shareholders (including the tax-exempt organization). Since the IRC provides that any dividend distribution received by a tax-exempt organization is excluded from UBIT, the tax-exempt organization is able to avoid UBIT.<a href="#_ftn1" name="_ftnref1">1</a> Most commonly, the UBIT blocker corporation is a regulated investment company (RIC, most commonly a mutual fund). The mutual fund acts as a UBIT blocker by investing directly in the MLP and paying dividends that are not subject to the UBIT.<a href="#_ftn2" name="_ftnref2">2</a> Through the use of the RIC UBIT blocker, the tax-exempt organization is able to avoid taxation at the rates applicable to trusts.<a href="#_ftn3" name="_ftnref3">3</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7773">7773</a> for more information on RIC investments in MLPs. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 512(b)(1); see also Internal Revenue Service Publication 598. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 512(b)(1). <a href="#_ftnref3" name="_ftn3">3</a>. IRC §§ 641(a); (1)(e). </div></div>

March 13, 2024

7774 / How are master limited partnerships (MLPs) treated under the passive loss rules?

<div class="Section1"> Investors are subject generally to an annual passive activity loss restriction. A passive activity loss is the amount for the taxable year by which aggregate losses from all passive activities exceed aggregate income from those activities.<a href="#_ftn1" name="_ftnref1">1</a> However, the IRC stipulates that the passive loss restriction applies for each individual MLP.<a href="#_ftn2" name="_ftnref2">2</a> Thus, a limited partner is not permitted to combine passive losses from any other MLP or from any other source.<a href="#_ftn3" name="_ftnref3">3</a> The result of the passive loss restriction is that a limited partner’s loss can only offset income from the master limited partnership that caused the loss. Congress has provided two avenues of relief from this restriction. If a limited partner has remaining passive activity losses, the losses are carried forward, and can offset future passive income of that MLP.<a href="#_ftn4" name="_ftnref4">4</a> Moreover, when a limited partner disposes of the entire interest in an MLP, any remaining passive losses may offset income from other sources.<a href="#_ftn5" name="_ftnref5">5</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8022">8022</a> for a detailed discussion of the passive loss rules. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 469(d)(1); see also Lowe v. Comm., 96 TCM 502 (2008). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 469(k). <a href="#_ftnref3" name="_ftn3">3</a>. H.R. Rep. 495, 100th Cong., 1st Sess. 951 (1987); S. Rep. No. 63, 100th Cong., 1st Sess. 187 (1987). <a href="#_ftnref4" name="_ftn4">4</a>. Id. <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 469(g). </div></div>

March 13, 2024

7771 / Can a master limited partnership (MLP) become subject to the unrelated business income tax?

<div class="Section1"> Although the tax benefits that can be realized through investment in MLPs have generated much interest among investors, it is, as always, important that advisors counsel investors about the pros and cons of MLP investing before allocation of MLP interests for their portfolios. As noted in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7768">7768</a>, one attractive feature of the MLP is that it is subject to only one level of taxation. Despite this, certain tax-preferred entities (such as 401(k)s and IRAs) and organizations (such as charities and churches) may actually run afoul of a different tax as a direct result of their investment in MLPs. Like individual taxpayers, certain tax-preferred entities (such as 401(k)s and IRAs) and organizations (such as charities and churches) can become limited partners upon investment in a MLP. However, any income derived from the partnership will be subject to the unrelated business income tax (UBIT), as this income will be classified as unrelated business taxable income (UBTI) to such entity or organization.<a href="#_ftn1" name="_ftnref1">1</a> UBTI is “gross income derived by any organization from any unrelated trade or business . . . regularly carried on by it.”<a href="#_ftn2" name="_ftnref2">2</a> An “unrelated trade or business” is defined to include “any trade or business the conduct of which is not substantially related . . . to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption.”<a href="#_ftn3" name="_ftnref3">3</a> MLP income distributed to a tax-exempt entity or organization will very likely constitute UBTI. For example, income that is passed through to a 401(k) or IRA based on an investment in a MLP is not related to a retirement account’s tax-exempt purpose of encouraging taxpayers to save for retirement and, therefore, will become subject to the UBIT. Additionally, if a tax-exempt organization invests directly in a MLP, any partnership income will become subject the applicable corporate tax rates, because that income is not related to the organization’s exempt purpose.<a href="#_ftn4" name="_ftnref4">4</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 408(e)(1), 511; see also Joint Committee on Taxation pg. 25, 26. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 512(a)(1). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 513(a); see also United States v. Am. College of Physicians, 475 U.S. 834, 838 (1986). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 11. </div></div>

March 13, 2024

7773 / Can a regulated investment company (RIC) invest in a master limited partnership (MLP)?

<div class="Section1"> In the past many mutual funds have been reluctant to invest in MLPs because of the RIC investment restrictions of IRC Section 851. To maintain its RIC election, a RIC must derive at least 90 percent of its gross income from certain sources specified within the IRC, including dividends and interest.<a href="#_ftn1" name="_ftnref1">1</a> Because as a partnership, an MLP does not distribute “dividends,” a RIC was unable to derive more than 10 percent of its income from MLPs. However, in 2004 Congress amended IRC Section 851 to provide that a RIC may include “net income derived from an interest in a qualified publicly traded partnership” in calculating its 90 percent income requirement.<a href="#_ftn2" name="_ftnref2">2</a> Essentially, this amendment provided mutual funds the ability to diversify their portfolios because any income derived from the MLP will not affect its status as a RIC. A RIC still faces limitations in its ability to invest in MLPs. A mutual fund is not permitted to invest more than 25 percent of its assets in a MLP.<a href="#_ftn3" name="_ftnref3">3</a> Nor are mutual funds permitted to own more than 10 percent of the interests issued by a MLP.<a href="#_ftn4" name="_ftnref4">4</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7922">7922</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7935">7935</a> for a detailed discussion of the rules governing RICs. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC §§ 851(b)(1), (2). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 851(b)(2)(B); see also Public Law 108-357 § 331 (2004). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 851(3)(B). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 851(3)(B). </div></div>

March 13, 2024

7775 / What are some of the potential advantages of investing in a master limited partnership (MLP)?

<div class="Section1"> As discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7768">7768</a>, a primary advantage of the MLP structure is that it avoids double taxation through its characterization as a pass-through entity. Additionally, many investors are attracted to MLP investments because of this type of security’s typically high returns. MLPs entice investors by contractually agreeing to distribute all available cash on a quarterly basis, although the general partner may have the discretion to hold reserves in order to carry on the operations of the business.<a href="#_ftn1" name="_ftnref1">1</a> Equally beneficial for investors is the fact that most partnership agreements create a subordination period provision, which usually places the sponsor’s limited partnership interest on hold. Effectively, this provision allows for sufficient cash flow to be distributed so that common units receive minimum distribution levels.<a href="#_ftn2" name="_ftnref2">2</a> It is also important to note that distributions issued to limited partners are tax-deferred as these distributions are treated as a return of capital. The distributions act to reduce a limited partner’s basis to the point of that partner’s cost basis.<a href="#_ftn3" name="_ftnref3">3</a> Once that basis reaches zero, any subsequent distribution is then taxed at current tax rates.<a href="#_ftn4" name="_ftnref4">4</a> However, investors should be aware that a MLP may lose its tax advantages if there is a sale or exchange of 50 percent or more of the interest in partnership capital or profits.<a href="#_ftn5" name="_ftnref5">5</a> The sale or exchange of 50 percent or more of partnership interests leads to the characterization that a new partnership has been formed. The dissolution of the former entity may lead to a recapture of credits that would correspondingly flow through to the individual MLP investors. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. John Goodgame, Master Limited Partnership Governance, 60 Bus. Law. 471, 474-5 (2005), at 474, 475. <a href="#_ftnref2" name="_ftn2">2</a>. Id. at 476. <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 733. <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 731(a)(1). <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 708(b). </div></div>

March 13, 2024

7768 / What is a master limited partnership (MLP)?

<div class="Section1"> A master limited partnership (MLP) is a business entity that arose as a result of the desire of business owners to take advantage of characteristics of both corporate and partnership business entities. At the most basic level, the MLP is a type of publicly traded entity that is taxed as a partnership, but publicly traded on a national securities market in the same manner as corporate stock.<a href="#_ftn1" name="_ftnref1">1</a> Generally established as LLCs with advantageous partnership flow through tax treatment, MLPs present attractive return vehicles to attract long-term capital to the energy extraction, energy transportation (“midstream”), and energy distribution (“downstream”) markets.An MLP is required to pay out most of its annual income to investors ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7769">7769</a>) and is permitted to carry on an active business. Distributions issued to limited partners are treated as a return of capital; the distributions issued act to reduce a limited partner’s basis to the point of that partner’s cost basis.<a href="#_ftn2" name="_ftnref2">2</a> Once that basis reaches zero, any subsequent distribution is then taxed at current tax rates.<a href="#_ftn3" name="_ftnref3">3</a> The MLP business entity allows for some corporate characteristics to persist: limited liability to investors and publicly traded units. Also, the MLP provides the tax advantages of a pass-through entity partnership. As such, partners are generally permitted to take into account any loss, deduction or credit produced by the partnership at the individual level, while avoiding taxation at the entity level.<a href="#_ftn4" name="_ftnref4">4</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 7704(b). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 733. <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 731(a)(1). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 702; see also Joint Committee on Taxation, Tax Treatment of Master Limited Partnerships, (JCS-18-87), June 29, 1987 at 6. </div></div>