- The pass-through structure of MLPs provides significant tax efficiency but comes with some complexities that are important for investors to understand.
- The majority of MLP distributions are generally tax-deferred, with the remainder taxed as ordinary income in the current year.
- MLP investment products provide exposure to MLPs without the hassle of K-1 forms but have their own tax and suitability nuances to consider.
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 thedeath 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.
Investing directly in MLPs may be less desirable for some investors.
While MLPs provide tax benefits for US investors, foreign investors can face high tax rates if they invest in MLPs. As a result of US tax law, MLPs are required to withhold taxes from the distributions of foreign unitholders at the highest individual tax rate (37%). Foreign investors can potentially avoid this withholding by buying swaps on MLPs. In a total return swap, a bank or other counterparty purchases the underlying asset (MLPs) and pays the distribution and capital gains to the investor in exchange for a negotiated borrowing rate.
Another potential issue for investors is Unrelated Business Income Tax (UBIT), which can arise when a tax-advantaged account directly invests in MLPs. UBIT is generated when Unrelated Business Taxable Income (UBTI) exceeds $1,000 in a given year, as the tax is designed to prevent unrelated business activity within a tax-exempt vehicle such as an IRA or 401(k). The good news for ETF investors is that you do not need to worry about UBTI if you are invested in an MLP ETF in a tax-advantaged account like an IRA (Read More).
Tax considerations for MLP investment products.
When considering MLP investment products, it’s important to keep in mind their tax implications and how they differ from individual MLPs. First of all, MLP access products generally issue a single form 1099, which means you do not receive a Schedule K-1. Instead, K-1 forms are processed by the product issuer, and they distribute a 1099 form to investors.
Products also have different tax characteristics depending on structure (see graphic below). C-Corp funds — funds that own more than 25% MLPs — are taxed as corporations (currently 21%). Because the fund’s earnings are taxed, the product issuer withholds a certain amount at the fund level to pay taxes and accrues a deferred tax liability or asset. The result is that the fund will not perfectly track the underlying securities when it is in a net deferred tax liability status. For example, if the underlying securities appreciate by 10%, the fund will only appreciate by 7.9%. The fund's distribution, however, retains the tax characteristics of the underlying securities. As a result, a significant portion of fund distributions will typically be treated as a tax-deferred return of capital, with the remainder taxed at qualified dividend rates (which share similar tax treatment as long-term capital gain rates).
RIC-compliant funds (those that hold less than 25% MLPs) do not pay taxes at the entity level as pass-through entities. As a result, there is no tax drag on performance, making them attractive for tax-advantaged investors interested in total return. In contrast to C-Corp funds, more of the distribution from RIC-compliant funds is taxed as qualified dividends rather than tax-deferred return of capital. As a result, when combined with lower exposure to MLPs, RIC-compliant funds generate lower after-tax income compared to C-Corp funds. Exchange-traded notes (ETNs) are different than funds in that they are debt obligations issued by a bank who agrees to provide the return of an underlying index minus fees. ETN coupons are taxed at the ordinary income rate. ETNs, like RIC-compliant ETFs, do not have a tax drag on capital appreciation. For more information on MLP access products, please refer to our piece from January.
While the tax benefits of MLPs can be complex, the investment story for MLPs is simple in contrast. Growing production of US oil and natural gas will increasingly be exported overseas to meet rising global demand, requiring additional energy infrastructure such as pipelines, storage terminals, and natural gas processing plants. MLPs benefit as fee-based businesses, generating cash flows through long-term contracts with customers for the volumes handled by those assets.