Understanding MLP Taxation / The tax implications of investing in master limited partnerships.

Matthew Coffina for Morningstar writes:  Master limited partnerships, or MLPs, can be an attractive alternative for investors seeking current yield and income growth. However, MLPs have different tax circumstances than common stocks, and you would be well advised to understand the tax implications before investing in MLPs. What follows is my best attempt to explain the key tax considerations. Please note that none of this is intended as tax advice, nor is it meant to be a comprehensive discussion. Please consult a tax professional for any questions about your personal situation.

The reason that master limited partnerships exist is to avoid paying corporate income taxes. Most publicly traded companies are organized as C corporations, named after their subchapter in the U.S. Internal Revenue Code. C corporations are treated as separate legal entities and have to pay corporate income taxes (generally 35% in the U.S., plus state taxes). Any dividends that C corporations pay to their owners (shareholders) are taxed again, as personal income. Until 2003, dividends were taxed at the ordinary income tax rate. 

The Bush-era tax cuts reduced the maximum tax rate faced by U.S. shareholders on qualified dividends to 15% as a way to mitigate the double taxation of corporate income and to equalize the treatment of dividends and capital gains. Subsequent legislation raised the maximum dividend tax rate for those in the highest income bracket to 20% starting this year.

Partnerships are different, in that they are not considered separate entities from their owners for tax purposes. Instead of paying corporate income taxes, MLPs pass their tax liability through to unitholders (ownership interests in MLPs are called "units" rather than "shares"). At tax season, investors receive a Schedule K-1 for each MLP owned, which informs them of their share of the MLP's profits. 

Importantly, investors owe taxes solely on their share of an MLP's taxable income each year, which is only indirectly related to cash distributions. The cash distributions themselves are treated as a return of capital for tax purposes, which reduces the investor's cost basis. In most cases, MLPs can use depreciation (a noncash expense) to reduce reported net income below the level of cash that is actually available to be paid out as distributions. Effectively, a portion of the cash distributions benefit from a deferral of taxes, as only the amount of taxable income is taxed (at the ordinary income tax rate, not the qualified dividend rate). Of course, there's a catch--any deferral of tax is recaptured when the units are sold.

I will illustrate with a highly simplified example. Say I buy 10 units of an MLP with a unit price of $100, for a total outlay of $1,000. I hold for just over one year and then sell my units for $105, for a 5% capital gain. During the year, the MLP pays me a 5% distribution, so $50 total. I am allocated taxable income of $25. The difference between the cash distribution and the allocated taxable income is due to depreciation and treated as a return of capital. Let's assume I'm in the 25% tax bracket.

So, what do I owe in taxes? The $50 distribution I received is not taxed directly. Instead, I owe 25% tax on my $25 share of taxable income, or $6.25. I also owe taxes on my $50 capital gain. Since I held for just over a year, I am eligible for the 15% maximum tax rate on long-term capital gains, so I owe an additional $7.50. Lastly, my cost basis has been reduced by the $25 of excess depreciation. This portion is treated as a recapture of past depreciation deductions and is not eligible for the preferential long-term capital gains tax rate. Instead, I have to pay tax at my 25% ordinary rate, for an additional $6.25 outlay. 

In this example, my pretax return was $100, or 10%--the 5% distribution plus the 5% capital gain. My total tax bill was $20 (=$6.25+$7.50+$6.25). My effective tax rate was 20%--$20 in taxes divided by my $100 pretax return. Note that this is above the 15% rate that applies to most long-term capital gains and qualified dividends in the U.S. (except for investors in the top tax bracket). However, there is a significant tax advantage to MLPs that my one-year example doesn't account for. The tax on capital gains and recaptured depreciation can be deferred as long as I don't sell my units. This is one of the reasons why it generally doesn't make sense to own MLPs in a tax-deferred account such as a 401(k) or IRA. The MLP already has an embedded tax deferral.

The other and far more important reason not to own MLPs in a tax-deferred account is that the Internal Revenue Service only exempts such accounts from $1,000 in "unrelated business taxable income," or UBTI. If your retirement account is allocated more than $1,000 in UBTI from all sources, you will have to file an entirely separate tax return (Form 990-T) on behalf of the account and pay taxes on any amount above $1,000, generally at a rate above your personal tax rate. Not only would this be a huge drag on performance, but it also would introduce a lot of unnecessary complexity. For this reason, we usually recommend investors keep any MLP investments in a taxable account.

The other big potential problem with MLP taxation comes from state-level taxes. Many MLPs operate across multiple states, and if you generate enough income in those states, there is a risk that you could be expected to file tax returns for each of them. The good news is that states generally allow you to forgo filing a return as long as your income in that state is below certain minimum thresholds. Since allocated taxable income tends to be a fraction of cash distributions, and that taxable income is often spread across multiple states, we usually don't have to worry about this. However, if you plan to make a large investment in MLPs, this is an issue worth investigating in advance.

As a general rule, it is almost impossible to determine what your taxes are going to be ahead of time with an MLP or to try to track the relevant information on your own. Fortunately, MLPs tell you everything you need to know on the Schedule K-1. However, this can add directly to your tax preparation costs if you use an accountant, or it will involve some extra steps in TurboTax or similar software if you do your own taxes.

The upside is that the extra tax complication scares many other investors away, which creates opportunities for those of us willing to do the paperwork. Morningstar StockInvestor has done exceedingly well with its MLP investments, including current holdings  Energy Transfer Equity (ETE) and  Enterprise Products Partners (EPD). I expect MLPs to remain a part of our strategy for the foreseeable future, as few other areas of the market offer the same combination of mid-single-digit yields, distribution safety, and growth ahead of inflation.