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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 investors and the sponsoring companies to reap 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 a few headaches at tax time. For investors willing to push through the extra paper work when they file, the benefits of owning MLPs outweigh those issues.

Defining MLPs

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 the construction of dwindling domestic energy infrastructure, Congress made some changes to that tax code in 1986. Those changes allowed for pipeline firms to be structured as partnerships, which meant that the income the MLPs distributed avoided the double taxation that corporate dividends typically suffer. Dividends that are paid out of earnings are 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. That 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, such as 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.

Taxation

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Here’s where things get a little tricky for investors in MLPs, as the partnership structure can throw investors for a loop during tax time. Firstly, because MLP distributions aren’t considered dividends, MLP unit holders don’t receive a Form 1099. Instead, unit holders receive a K-1 statement typically mailed to out in March. On it, investors will see their share of the income, deductions, credits and other items associated with owning the MLP. The K-1 is not filed with the personal income tax return, but rather the data is used to fill out portions of the personal tax return. While it can be confusing, most qualified professionals and tax software can handle the additional paperwork.

Additionally, almost all MLPs have special K-1 help lines and websites available for more assistance with preparing returns.

Secondly, due to depreciation allowances on capital equipment, pipelines, storage tanks, etc., 80% to 90% of the distributions investors receive from a typical MLP are considered a return of capital by the IRS. Taxes aren’t immediately paid on this portion of the distribution, however, the remaining piece of each distribution is taxed at normal income tax rates.

The return of capital portion is used to reduce an investor’s cost basis in the MLP, and that portion is not taxed until the MLP units are sold. For example, if buying units in Kinder Morgan (KMP) at $50 with $5 in annual distribution payments, roughly $4.50 of that would be considered a return of capital. After one year, the cost basis on the MLP would drop to $45.50 ($50 minus $4.50). No tax is owed on the $4.50, but normal income tax rates on the remaining 50 cents would apply.

When selling the units, investors will pay more taxes on the lower cost basis since their capital gain will be higher. Likewise, once the cost basis hits zero, the distributions then become fully taxable. However, there are plenty of “tricks” to limit one’s liability as the 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 be required to file 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 investors 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.

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Disclosure: No positions at time of writing.

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