Investors have long been attracted to MLPs for their generous yield, but a recent survey of over 600 financial advisors shows that the tax advantages of MLPs — including the potential for tax-deferred income — are not well understood.
Only 22% of respondents indicated that they are very familiar with the tax advantages of MLPs; several respondents noted that more education was necessary to make midstream/MLP investing more attractive.
A common misconception is that MLPs will come with the added complexity of a K-1 for tax reporting. While direct investments in MLPs will come with a K-1, investors can gain diversified exposure to MLPs through exchange traded products and other investment funds that provide a Form 1099 instead, according to Alerian.
MLPs pay no taxes at the entity level if 90% or more of their income is from qualifying sources. Due to the tax efficiency of the structure, MLPs have a lower cost of capital as compared to traditional C-corporations.
MLPs do not have the double taxation associated with corporate dividends and have historically provided attractive income that is largely a tax-deferred return of capital, according to Alerian.
In more detail, a unitholder’s cost basis is adjusted upward by the amount of partnership income allocated to that unitholder and adjusted downward by the amount of cash distributions (or actual payments) received.
For most MLPs, cash distributions exceed allocated income, and the difference between distributed cash and allocated income is treated as “return of capital” to the unitholder and reduces the unitholder’s basis in the units, according to Alerian.
Typically, 70%-100% of MLP distributions are considered tax-deferred return of capital, with the remaining portion taxed at ordinary income rates in the current year.
As long as the investor’s adjusted basis remains above zero, taxes on the return of capital portion of the distribution are deferred until the units are sold. However, if an investor’s basis reaches zero, then future cash distributions will be taxed as capital gains in the current year, according to Alerian.
Upon selling the MLP, the gain resulting from basis reductions is recaptured and taxed at ordinary income rates, and any remaining gain is taxed at capital gain rates for investments held greater than one year, according to Alerian.
An MLP unitholder is responsible for paying state income taxes on the portion of income allocated to the unitholder for each individual state in which the MLP operates; however, in most cases, unless the unitholder owns a large position, the share of allocated income is small, and the unitholder may not have to file in some states due to minimum income limits, according to Alerian.
If an investor is looking to own an MLP in a tax-advantaged account such as an IRA, partnership income (not cash distributions) may be considered unrelated business taxable income (UBTI) and subject to unrelated business income tax (UBIT), if UBTI exceeds $1,000 in a year. The custodian of the IRA is responsible for filing IRS Form 990T and paying the taxes, according to Alerian.
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