A common theme among questions we get from new premium subscribers to our High-Yield Investing premium service has to do with taxes.

Specifically, readers want to know about a specific type of security’s tax treatment and whether it is suitable for a retirement account.

Another common question relates to the tax treatment of master limited partnerships, or MLPs.

While we are not here to offer specific tax advice to individuals, we can offer some thoughts. (Remember, everyone’s situation is different, so consult your tax professional if there’s ever any doubt.) Let’s dive in…

MLPs: A Recap

MLPs are special “pass-through” vehicles that combine the liquidity and accessibility of common stock with the tax advantages of a partnership. Ownership is divided up into units rather than shares, but they trade similarly on an exchange.

The key appeal of MLPs is simple: exemption from federal income taxes at the corporate level, provided they distribute at least 90% of their taxable income to unitholders.

This avoids the common “double taxation” problem with many publicly traded stocks, in which companies must pay corporate income taxes. Then, investors are taxed on any gains or dividends.

So, instead of sending a large cut of the profits off the top to Uncle Sam each year like an ordinary corporation, these businesses have more cash left to hand out to investors. As a result, they can afford to dish out attractive yields much higher than the market average.

This unique structure was designed to encourage investment in energy infrastructure such as oil and gas pipelines. Today, a handful of MLPs are involved in “upstream” production, while others own pipelines, storage terminals, processing plants, and other midstream infrastructure.

With that said, let’s get to the matter at hand.

How Are Master Limited Partnerships (MLPs) Taxed?

Due to their unique structure, MLP distributions are not treated the same as common stock dividends. While the distribution breakdown varies from company to company, a significant portion of distributions is generally considered “return of capital.”

The MLP can use depreciation and other deductions, leading to a tax-deferred distribution treatment. The return of capital is not taxed when received. Instead, it reduces your cost basis when you sell the MLP. The remainder is taxable as ordinary income.

Here’s an example…

Say you bought 1,000 units of an MLP at $35 each and decided to sell a year later (for an initial cost of $35,000). You received $5,000 in return of capital, so your reduced cost basis is $30,000. You also owe taxes on your share of the partnership’s annual taxable income of, say, $500. The $5,000 difference between your purchase price, the reduced cost basis, and the $500 of taxable earnings are taxed as ordinary income at your marginal tax rate.

If your marginal tax rate is 24%, you will pay $1,320 in taxes.

In contrast, let’s say you bought an ordinary stock that paid $5,500 in dividends. You would likely fall into the 15% tax bracket for qualified dividends and capital gains, so you would owe only $825 in taxes.

Keep in mind that this is not a perfect apples-to-apples comparison. But the point is that MLPs are not tax-free, as some commentators may suggest. However, they allow you to defer taxes until they are sold.

If you buy and hold an MLP, you can postpone the tax bite for a long time. But if you own the MLP so long that your cost basis falls to zero, you’ll pay taxes at the ordinary income tax rate on 100% of the cash distributions, regardless of whether they are return of capital or taxable earnings. However, the cost basis resets to the current market price on your death (also known as the “step up” basis). This makes MLPs an attractive long-term hold for your estate.

As with other investments, you are also taxed on the difference between your sales and purchase price at the long-term capital gains rate. For most filers, this will be 15%. If you sell your 1,000 units at $39, you will be taxed 15% on the $4,000 gain, or $600.

The Dreaded K-1

The company reports your taxable income and return of capital on a Schedule K-1 that you will receive in late February or early March.

Remember, since MLPs are partnerships, this shows your share of the MLP’s income. However, the actual cash you receive will often be much more than reported on the K-1 due to the return of capital.

That said, it’s generally best not to hold a large portfolio of MLPs in a tax-sheltered IRA account. That’s because your share of the MLP’s taxable earnings may be considered unrelated business taxable income (UBTI).

UBTI is taxable as ordinary income in your tax-sheltered account. However, your account won’t be taxed if the total UBTI from all your MLPs doesn’t exceed $1,000. And you may even have negative UBTI due to depreciation, depletion, or other non-cash charges. The negative UBTI can offset any positive UBTI from other investments in a tax year and is eligible to carry back or forward depending on individual circumstances.

Closing Thoughts

Let’s not lose sight of the main appeal of MLPs: income. But the tax benefits, while a bit complicated, can be appealing to some investors, too.

Again, everyone’s situation is different. You may want to consult your financial advisor or tax professional if you are unsure.

The rules surrounding MLP taxes are intricate. But don’t let that stop you from making a worthwhile investment decision. MLPs offer some of the highest yields on the market. And most are designed to grow their distributions yearly.

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