Swank Capital

MLP Asset Class | Tax Considerations

Master Limited Partnerships (MLPs) are similar to corporations in many respects, but differ in others, especially in the way they are treated for U.S. federal income tax purposes.  A corporation is required to pay U.S. federal income tax on its income, and, to the extent the corporation distributes its income to its shareholders in the form of dividends from earnings and profits, its shareholders are required to pay U.S. federal income tax on such dividends.  For this reason, it is said that corporate income is taxed at two levels.  Unlike a corporation, an MLP is treated for U.S. federal income tax purposes as a partnership, which means that no U.S. federal income tax is paid at the partnership entity level.  A partnership’s net income and net gains are considered earned by all of its partners and are generally allocated among all the partners in proportion to their interests in the partnership.  This information is reported to investors annually on Schedule K-1.  Each partner pays tax on its share of the partnership’s net income and net gains regardless of whether the partnership distributes cash to the partners.  All the other items (such as losses, deductions and expenses) that go into determining taxable income and tax owed are passed through to the partners as well.  Partnership income is thus said to be taxed only at one level—at the partner level. 

 

MLPs make distributions that are similar to dividends, and these are generally paid out on a quarterly basis. Although distributions from MLPs resemble corporate dividends, they are treated differently for U.S. federal income tax purposes.  A distribution from an MLP is not itself taxable (since income of the MLP is taxable to its investors even if not distributed) to the extent of the investor’s basis in its MLP interest and is treated as capital gain to the extent the distribution exceeds the investor’s basis (see description below as to how an MLP investor’s basis is calculated) in the MLP.  MLP unitholders are required to include their allocable share of the MLP’s income, gains, losses, deductions and expenses recognized, regardless of whether the MLP distributes cash to the unitholder. 

A unitholder's initial tax basis in MLP units is generally the amount he or she pays for the units.  The unitholder’s tax basis is subsequently (a) increased by the unitholder’s allocable share of the MLP’s net taxable income and certain MLP debt, if any, and (b) decreased by the unitholder’s allocable share of the MLP’s net losses and any distributions received by the unitholder from the MLP.  Thus, when the unitholder sells units, the taxable gain is the difference between the sales price and the adjusted basis. 

Quarterly cash distributions to MLP owners often exceed the partnership's income.  When this occurs, the difference is counted as a return of capital to the limited partners and is taxed at the capital gains rate when the unitholder sells.  Thus, instead of paying tax on the entire amount of cash distributions received, unitholders pay tax only on their share of the partnership's taxable income.  Any capital appreciation will be taxed at the capital gains rate (assuming the units are held for more than one year).  It is important to note that cash distributions are not guaranteed, and every unitholder is responsible for the taxes on his or her proportionate share of income, even if the MLP does not pay a cash distribution.

 

“This summary is based on current U.S. federal tax laws, regulations, judicial decisions, undertakings and rulings.  Changes in existing laws or regulations and their interpretation could alter the income tax consequences of an investment in MLPs or products which invest in MLPs.  This summary does not discuss all of the tax consequences that may be relevant to a particular investor or to certain investors subject to special treatment under the federal income tax laws, such as insurance companies, financial institutions or securities dealers. EACH PROSPECTIVE INVESTOR IS URGED TO CONSULT ITS TAX ADVISOR IN ORDER TO UNDERSTAND FULLY THE FEDERAL, STATE, LOCAL AND ANY FOREIGN TAX CONSEQUENCES OF AN INVESTMENT IN MASTER LIMITED PARTNERSHIPS.”