MLP (master limited partnership) tax considerations

2013.03.19 - MLP TaxesEnlarge GraphMLPs are unique

A master limited partnership (MLP)’s unique structure (as explained in Master limited partnership (MLP) basics exempts it from paying corporate-level taxes. The unitholders (that is, investors who own units of MLPs) are treated as if they’re directly earning the MLP’s income. They pay tax on the net income at their own marginal tax rate. Owners of MLPs must file a K-1 tax reporting form for each MLP name they own. The table above shows a simplified example of how taxes differently affect a C-Corp versus an MLP.

MLPs must pay out most of their excess cash flow in the form of distributions (similar to dividends) to unitholders. The distributions are treated as a return of capital under the tax code and aren’t taxed when unitholders received them. The basis in the partnership units is lowered by the amount of the distribution. When the unitholders sell their units, their taxable gain increases by the amount of the distributions. However, MLP unitholders do pay taxes on the taxable income of the MLP. To put it simply, MLP unitholders don’t pay taxes on the cash they receive from MLPs, but they do pay taxes on the taxable income of MLPs. Generally, investors receive higher cash payments than the amount by which they’re taxed (due to reasons such as depreciation and other tax deductions), allowing tax deferral.

MLPs and tax deferral

The table below shows a simplified example of how distributions are tax-deferred.

Time Period Time 0 Time 1 Time 2 Time 3 Time 4
Action Investor Buys MLP Unit for $100 Distribution of $10 Distribution of $11 Distribution of $12 Distribution of $13 and investor sells MLP unit for $120
Beginning Cost Basis N/A $100 $91 $81 $70
Allocation of Taxable Income N/A $1 $1 $1 $1
Cash Distribution N/A $10 $11 $12 $13
Reduction of Cost Basis N/A $9 $10 $11 $12
Ending Cost Basis $100 $91 $81 $70 $58
Taxes Paid at 30% Unitholder Tax Rate N/A 30% * $1 (unitholder tax rate * taxable income) = $0.30 30% * $1 (unitholder tax rate * taxable income) = $0.30 30% * $1 (unitholder tax rate * taxable income) = $0.30 30% * $1 (unitholder tax rate * taxable income) = $0.30
  • $120–$100 (sales price less purchase price) is taxed at the long-term capital gains rate of 15%: $20 * 15% = $3.00
  • $100 –$54 (purchase price less basis) is taxed at the unitholder’s marginal tax rate of 30%: $46 * 30% = $13.80.

A tax disadvantage

One tax downside to owning MLPs is that unitholders of MLPs must also file a Schedule K-1 for each individual MLP. The Schedule K-1 is a tax document that reports partnership interests. An investor can get around the K-1 requirement by investing in a vehicle such as an MLP exchange-traded fund (ETF), like the Alerian MLP ETF (AMLP). However, MLP ETFs have separate tax considerations that can make them more expensive than investing in individual MLPs.