The Tax Implications of Master Limited Partnerships

Over the last few decades, Master Limited Partnerships (MLPs) have gone mainstream. But what are MLPs? They are companies structured as partnerships and traded on the stock exchanges. You can buy units of the partnership as easily as you can buy common stock.

How Are Master Limited Partnerships Classified?

In order to be a classified as an MLP, the partnership needs to meet two qualifications:

1) The partnership must operate in an industry such as energy or natural resources
2) The partnership must distribute at least 90% of its income to its unitholders

By distributing more than 90% of its income the partnership avoids double taxation, which occurs when tax is paid by corporations first and capital gains tax is paid by individuals on dividends received. With MLPs, the partnership does not pay corporate tax and distributions to the unitholder will be higher because the tax is only paid once at the unitholder level.   

What Are My Tax Responsibilities If I’m Part of a Master Limited Partnership?

At year-end you will receive Form K-1 from the MLP, which allocates income based on your ownership percentage. Since these MLPs operate in a capital-intensive sector, most of the income that is allocated will in many cases be losses, due to the high rate of depreciation. And since you are considered a limited owner of the MLP, these losses will be deferred until you sell your units. On the other hand, the distributions are considered a return of capital and not taxed until you sell your units.   

As you can imagine, investing in MLPs introduces more complexity in the preparation of your taxes. In addition to Form K-1, you will be required to individually report each K-1 on your tax return. And the sale of any units in the MLP will require you to determine ordinary and capital portions of any gains, as both have different tax rates.

It is generally recommended that MLPs are held in taxable accounts because any distributions over $1,000 in a retirement account could result in Unrelated Business Taxable Income (UBTI) tax. This is a special tax accessed by the IRS and would cause additional fees charged by your brokerage. Both of these would reduce the appeal of the MLP structure.

ETFs vs MLPs

If you are interested in MLPs but don’t want to conduct in-depth research or deal with the complexity of tax preparation, you can find Exchange Traded Funds (ETFs) that will circumvent K-1 reporting and diversify company risk. However, keep in mind that the ETFs will be treated as a common stock, which would result in double taxation.

Master Limited Partnerships are complicated in nature and have various tax implications and strategies. If you need guidance on your MLP or EFT, please call Cray Kaiser for assistance.

Please note that this blog is based on tax laws effective in October 2021, and may not contain later amendments. Please contact Cray Kaiser for most recent information.

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