Arden Dale for the Wall St. Journal writes: Master limited partnerships, or MLPs, are touted as a way to capture dividend income and hedge against inflation. They also offer some tax advantages when held in taxable accounts.
But MLPs also can also create tax problems. And during this time of year as investors do their tax returns, those tax snares show up in stark relief.
State and federal tax requirements for MLPs are so daunting that some financial advisers recommend against them for that reason alone. Others warn that stashing MLPs in retirement accounts can cancel out the tax benefits.
"It is almost a situation of 'buyer beware' because in some instances, I've had clients not fully understand the tax consequences that come from investing until they file their returns," said James H. Guarino, an accountant and certified financial planner at MFA--Moody, Famiglietti & Andronico LLP in Tewksbury, Mass.
Publicly traded, MLPs finance the construction and operation of pipelines and other energy technologies. Since a partnership doesn't pay income tax as a corporation would before paying shareholder dividends, partners incur only one layer of tax and they can defer some of it. They also get a tax deduction for their share of depreciation on equipment.
The appetite in the U.S. for these investments is high, and more are being minted.
Yet advisers such as Mr. Guarino are quick to note potential problems. He sees more people who want to put partnerships into their individual retirement accounts. Those accounts already provide tax deferral, so the tax benefits of the partnership could well go unused. And, because partnership income over $1,000 is subject to a levy known as the Unrelated Business Income Tax, the retirement account may have to file a 990-T tax return and pay income tax.
Also of concern to many advisers is that reporting MLPs properly on state and federal tax returns can be a knotty and frustrating process. Not only do MLPs issue K-1s--notoriously complicated tax documents that often arrive just in the nick of time for the April 15 tax deadline--but some require tax returns and payments for numerous states.
State tax filing requirements can be so onerous that some advisers avoid MLPs on that score alone. The biggest problem is with partnerships that hold pipelines that run through many states. Each state sets an income threshold and an investor must file a tax return in a state if the partnership income exceeds that amount.
"One master limited partnership might give you exposure to 12 different states, and we don't want to put our clients in the position where they have to file those state taxes," said David S. Morgan, a principal at JMG Financial Group Ltd., an investment adviser in Oak Brook, Ill., with more than $1.4 billion under management.
His firm steers clients away from individual MLPs because of these "severe tax complications," Mr. Morgan said. Clients instead can get indirect exposure to partnerships--and without the tax issues--through exchange-traded notes, exchange-traded funds and mutual funds, he said.
Nevertheless, two clients of Mr. Morgan do invest directly and live with the tax consequences: One is the retired chief financial officer of an insurance brokerage, and the other a former colleague.
And, indeed, there are plenty of investors who are willing to take on the tax consequences.
Dave DeWitt, an adviser in Wayne, Pa., who manages MLPs for financial advisers and individual clients, has one client, a retired entrepreneur, with $10 million invested in them. Baby boomers looking for a good source of income, he said, can find that in partnerships.
"It's real assets, real pipes in the ground," Mr. DeWitt said.
Taxes? He leaves those issues to accountants like Dwight Beucler, who has a nearby accounting firm and a lot of experience with MLPs.
In the meantime, Mr. Beucler is currently knee-deep in tax filings for MLPs. He estimates he will spend three days entering information onto a tax return for one client who invests heavily in the partnerships. There are so many K-1s and other documents for the client, a retired chief executive, that he can't store them in a drawer as he does for other clients, but holds them in special three-ring binders.
"I have someone check my work," said Mr. Beucler.
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