When rates hover around zero, investors often find themselves looking towards more “exotic” asset classes to gain yield. Everything from convertible bonds to emerging market debt becomes commonplace in portfolios. One of the more popular choices is master limited partnerships or MLPs. The corporate tax structure allows for investors and the sponsoring companies to reap some pretty nice benefits, including big dividend distributions [for more MLP news and analysis subscribe to our free newsletter].
However, those juicy dividends do come with some headaches at tax time. But for investors willing to push through the extra paper work when they file, the benefits of owning MLPs outweigh those issues.
All across the country, pipelines, petroleum storage tanks and switching terminals help move traditional and unconventional energy from the wellhead to processing facilities. Big dollars can be made in supplying and owning that infrastructure—especially for firms using an obscure piece of the tax code from 1986 [see also How To Profit From Record U.S. Oil Production].
As a way to stimulate construction of dwindling domestic energy infrastructure, Congress made some changes to the tax code back in 1986. Those changes allow for pipeline firms to be structured as partnerships, allowing the income that MLPs distribute to avoid the double taxation that corporate dividends suffer. Dividends that are paid out of earnings get taxed twice, once at the corporate level, then again as a taxable gain to shareholders.
The sponsoring firms—known as the general partners (GP)—avoid taxation on assets placed within the MLP and gain from increasing incentive distribution rights as the MLP grows.
Not every firm meets the requirements of becoming an MLP. The section of the tax code specifically lays out that those businesses whose “income and gains [are] derived from the exploration, development, mining or production, processing, refining, transportation or the marketing of any mineral or natural resources” can qualify. While some “non-energy” MLPs do exist—like cemetery firm StoneMor Partners (STON)—the bulk of these firms focus on transportation or extracting hydrocarbons.
The benefits to individuals owning shares (or units) in an MLP include dividends in the 5-9% range as well as deferring a portion of those dividends come tax time.
Here’s where things get a little tricky for investors in MLPs, as the MLP partnership structure throws tax time for a loop. First, because MLP distributions aren’t considered dividends, MLP unit holders don’t get a Form 1099 at tax time. Instead, unit holders receive a K-1 statement typically mailed to owners in March. On it, you’ll see your share of the income, deductions, credits and other items associated with owning the MLP. You do not have to file the K-1 with your personal income tax return, but instead, you will use the data on the form to fill out portions of your personal tax return. While it can be confusing, most qualified professionals and tax software can handle the additional paperwork.
Additionally, almost all MLPs also have special K-1 help lines you can call and websites you can visit for more assistance with preparing your return.
Secondly, due to depreciation allowances on capital equipment—pipelines, storage tanks, etc.—80% to 90% of the distributions you receive from a typical MLP are considered a return of capital by the IRS. You don’t pay taxes immediately on this portion of the distribution; however, the remaining piece of each distribution is taxed at normal income tax rates [see also How to Profit From a Keystone XL Pipeline Approval].
The return of capital portion is used to reduce your cost basis in the MLP, and you’re not taxed on the return of capital until you sell the units. For example, if you buy units in Kinder Morgan (KMP) at $50 and receive $5 in annual distribution payments, roughly $4.50 of that would be considered a return of capital. After one year, your cost basis on the MLP would drop to $45.50 ($50 minus $4.50). No tax is owed on $4.50, while normal income tax rates on the remaining 50 cents would apply.
When you finally sell the units, you’ll pay more taxes on the lower cost basis as your capital gain will be higher. Likewise, once your cost basis hits zero, the distributions then become fully taxable. However, there are plenty of “tricks” to limit one’s liability as that date approaches. Skillful tax preparers should be able to handle that scenario as it comes up.
Finally, investors with large stakes in some MLPs may require filing taxes in every state in which the MLP operates. Technically, when you own an MLP you are considered to be earning income in every state it has a pipeline or gathering system. However, for most regular retail investors, this simply isn’t a factor as most “energy” states have zero income tax or have high minimum MLP income limits [see also 25 Ways To Invest In Crude Oil].
The Bottom Line
Despite the various tax complications, investors choosing master limited partnerships for a portion of their dividend income can be richly rewarded. The extra “hassles” shouldn’t scare portfolios away from holding the security type. As the asset class has grown in prominence among investors, tax preparers and software have gotten better at handling K-1 statements and cost basis tracking.
Disclosure: No positions at time of writing.