MASTER LIMITED PARTNERSHIPS (MLPs)
December 11, 2013
Master Limited Partnerships (MLPs), also known as Publicly Traded Partnerships (PTPs) have become popular investment vehicles in recent years. They are a refinement of the limited partnerships (Shelter LPs) that were in vogue in the tax shelter era of the 1970s. The following discussion addresses the tax implications of MLPs and is subject to the prime directive that investments should be evaluated as investments first, and then consideration should be given to the tax issues as a refinement to that analysis.
Unlike the Shelter LPs, MLPs trade like stocks on pubic exchanges, are priced like stocks (i.e. not in terms of thousands of dollars per units), and usually own operating businesses rather than real estate.
Unlike stocks, however, MLPs are subject to an entirely different tax structure and this gives rise to the complications of owning MLPs. MLPs operate within the partnership tax rules, which were first enacted in the simpler days of local businesses and professional firms operating in partnership format. Thus, today’s MLPs operate under tax rules that really are a suit made for a thinner and shorter person. Add the complexity of the passive loss rules and you have tax reporting that is a quantum leap from that associated with stock ownership.
First, MLPs do not pay tax; the partners pay tax on their pro rata share of the partnership income. As an economic concept, this is a plus (avoiding the double layer of taxes in the corporation/shareholder relationship). But this is where complications start. Under the partnership rules, the partnership activity must be ‘separately stated’, i.e. unlike a corporate dividend, where the income is one number, reported as a dividend, partnerships report the activity on a Schedule K-1 (copy attached). Therefore, operating income (or loss) is reported on Schedule E (either page 1 or page 2, depending on the type of activity), interest and dividend income on Schedule B, credits on the applicable credit schedule, etc.
Second, operating losses and real estate losses in turn are subject to the passive loss restrictions, which means that, generally, the losses are not deductible until there are items of passive income or until the investment is sold. Curiously, passive losses for non-public partnerships are reported on the tax return and tracked as a carry forward; however, MLP losses are not reported and therefore must be tracked on separate work papers.
Third, MLP distributions are not subject to tax (unless the distribution exceeds the remaining basis). In many cases, that means that investors receive tax deferred (not tax free) distributions. On the other hand, if distributions exceed basis, then income is recognized.
Fourth, when the MLP is sold, the difference between the sales price and the basis will be taxable gain. Now we arrive at a complication. The amount of cost basis reported on the brokerage statement is in fact not the real basis. For an MLP unit, the cost basis is increased by any income reported to the partner, but reduced by any losses, deductions or distributions. However, these amounts are not tracked by the brokerage firm.
All of this means that when an MLP unit is sold, the basis must be recalculated to determine the gain or loss, and how much is capital gain and how much is ordinary gain. On the other hand, the suspended losses (see above) that have floated in the background now become deductible.
Fortunately, some of the information is usually available at the MLP’s website; log onto the website, enter the taxpayers Social Security Number, and the underlying tax data is reported. The other will have been maintained by the tax return preparer. Nonetheless, there will be a significant amount of information to be inputted to cover all the tax bases.
With MLPs, as with any investment, the first question is the investment quality. Once the investor is comfortable with the MLP as an investment, consider the tax ramifications. The fact that the MLPs do not pay taxes is, economically, an additional advantage. The caveat is the cost of dealing with tax complexity and the taxes due at sale.
*IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
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