Now that we’ve learned about MLPs’ distributions, let’s see how distributions, or MLP investors, are taxed. MLPs are pass-through entities that pay no taxes. Unitholders, as limited partners, are taxed. Each unitholder is allocated on paper a proportionate share of an MLP’s income, gains, deductions, losses, and credits, reported annually on a K-1 form. The K-1 is a tax document that reports partnership interests.
Distributions are considered returns of capital under the tax code and aren’t taxed when received. Usually, 80%–100% of MLPs’ distributions are tax deferred.
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The above example and the following discussion are for informational purposes only and shouldn’t be construed as offering tax advice.
Basis is used to determine your gain or loss when you sell your units. Your initial basis is the price you paid for your units. Your share of taxable partnership income each year adjusts your basis upward. Your share of deductions—for example, depreciation—adjusts it downward.
Cash distributions are considered returns of capital and adjust your basis downward. Thus, when you sell your units, your taxable gains—that is, your sale price on an adjusted basis—are increased by the amount of your distributions.
Generally, distributions are greater than net taxable income because of deductions such as depreciation. As long as this holds true, taxes on distributions are deferred.
The gains resulting from basis reductions due to depreciation are taxed at ordinary income rates. This practice is called “recapture.” The remaining portion is taxed at capital gains rates.
You can avoid dealing with tax nuances and the pain of filling out K-1 forms by investing in ETFs such as the Alerian MLP ETF (AMLP). AMLP, structured as a corporation, handles all K-1s and sends investors a single 1099, which is much easier to handle.
Through AMLP, you can get exposure to well-known MLPs such as Enterprise Products Partners (EPD), Plains All American Pipeline LP (PAA), Magellan Midstream Partners (MMP), and Energy Transfer Partners LP (ETP).