The IRS (Internal Revenue Service) considers MLPs to be pass-through entities, so they are not required to pay corporate level federal income taxes. A percentage of the cash distribution a unit holder receives is tax deferred, unless investors sell their units.
In the above graph we can see how MLPs generate more returns as compared to C-Corps because of their structure. However, MLPs may be required to pay the state tax where they operate. Let’s consider an example to explain how an individual unit holder is taxed.
Adjusted basis example
In the above example, an investor receives $2.50 per unit as total cash distribution. The investor’s taxable income is $2.50 minus $1.00 of depreciation, which comes to $1.50 per unit. Gain per unit is calculated as purchase price minus adjusted basis, which comes to $3,000 per unit.
Investors who buy units of MLPs file a K-1 form, which contains information regarding unit holders’ shares allocated to them, their net income, gain, loss, and deductions. Investors who invest through any ETF like the Alerian MLP ETF (AMLP) file a 1099 form instead of a K-1 form.
Among the MLPs in which an investor can invest directly are Magellan Midstream Partners (MMP), ONEOK Partners (OKS), Plains All American Pipeline (PAA), and MarkWest Energy Partners (MWE). These MLPs have a combined weight of 28.5% in the Alerian MLP ETF (AMLP).
In the next article, we’ll discuss the reasons to invest in MLPs, their advantages and disadvantages, and the performance of MLP ETFs as compared to other asset classes.