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Tax complexity of MLPs is a significant negative [ClearOnMoney]
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Tax complexity of MLPs is a significant negative

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Commentary

Tax complexity of MLPs is a significant negative

22 Feb 2013 by Jim Fickett.

One often sees investment pitches these days for Master Limited Partnerships (MLPs). A typical MLP owns pipelines and earns fee income from the transportation or gas or oil. MLPs are attractive because, like REITs, they pass on most income to investors and avoid the double taxation of corporations. The two main drawbacks of MLPs are (1) they are difficult to value, and (2) tax treatment is complex. I'll come back to the first point another time. This post gives a summary of the tax complexity.

There is a very nice overviwe overview of the advantages and disadvantages of MLPs available from the investment consulting firm NEPC, entitled Investing in master limited partnerships: risks and opportunities. Here is the main passage of that report dealing with tax:

An MLP structure appeals to many natural resource-related businesses because of the tax shield which provides higher net income at the partnership level. This means that distributions are higher; however, the tax burden has been shifted to the investor. The administrative burden and potentially confusing nature of the unique tax treatment is the main reason institutional investors have historically not invested in the space.

MLP distributions are tax-deferred but MLP investors are responsible for the taxes allocated to each unit’s share of net taxable income. The net taxable income is adjusted for deductions and gains and is payable even if an MLP does not make a distribution in a given period. Typically, MLPs are able to minimize the amount of taxable income through the depreciation, depletion, and amortization of assets. Net taxable income is generally 10-20% of an MLP’s total distributable cash flow, meaning that investors are effectively receiving distributions that are 80-90% tax-deferred.

Distributions to unit holders are classified as return of principal and remain tax-deferred until the units are sold or the cost basis reaches zero. Once a unit is sold or the cost-basis reaches zero, an investor is responsible for the taxes on the distributions that have been deferred to this point (cost basis minus adjusted cost basis). An investor is also responsible for the taxes on this portion of the taxable income once the unit is sold or the cost basis reaches zero. Any capital appreciation gain from the sale of an MLP unit is taxed at the standard capital gains rate.

Direct investors in MLPs also have to deal with the administrative burden of the IRS K-1 forms (instead of Form 1099) issued by each individual MLP. The K-1 includes information regarding a unit holder’s share of partnership net income, gain, loss, and deductions. Investors are required to file income tax returns (and responsible for the potential tax burden) in each state in which an MLP generates income.

So you have an extra form to deal with, the K-1, and more rules of the tax code to read. In addition you have to watch carefully for when your cost basis is reduced to zero, and remember to pay the deferred taxes that year. The biggest potential disadvantage of an MLP investment is the one mentioned right at the end, of owing taxes in every state in which the MLP operates. Since pipeline companies operate across many states, this could be quite a headache. Fortunately, for retail investors, this is typically only a minor hassle, because your income in any one state is likely to be below the threshold requiring a return to be filed. The Investing Daily explains:

one common push-back you will hear about investing in MLPs is that you’re required to file taxes in every state in which the MLP operates. That’s only partially true.

It is true that when you own an MLP you are considered to be earning income in every state in which that MLP operates. However, in most cases unless you own a large position in the MLP it’s likely you will not have to file a return in every state or pay any state taxes outside your home state. There are two main reasons for this.

First, many key states in which MLPs operate don’t have state income taxes at all. Examples include Texas and Wyoming, both xtates where MLPs are extremely active.

Most others have minimum income limits; unless you have income from the MLP above that limit you’re not required to file state taxes.

As most MLPs operate in multiple states, the share of income allocable to each individual State is quite small; typically only investors with large holdings will need to file. The exact amount of income allocable to each individual State is included in your K-1 form.

So the bottom line is that owning an MLP does add significant, but probably not catastrophic, complexity to the tax return process. Each investor will have to weigh the advantages and disadvantages.