MLPs are well-known for offering generous yields to investors, but the tax implications of MLPs are often misunderstood.
MLPs are a highly tax-efficient way to own midstream energy infrastructure assets, and ETFs holding MLPs, such as the Alerian MLP ETF (AMLP) and the Alerian Energy Infrastructure ETF (ENFR), offer an easy way for investors to gain diversified exposure to the industry.
Many advisors are wary of investments in MLPs due to the assumption there will be an added complexity of a K-1 for tax reporting. However, while direct investments in MLPs will come with a K-1, ETFs issue a single 1099 form instead. K-1 forms are processed by the issuer of the ETF, and investors are then given a 1099 form.
MLPs pay no taxes at the entity level if 90% or more of their income comes from qualifying sources. MLPs do not have the double taxation associated with corporate dividends and therefore have historically provided attractive income that is largely a tax-deferred return of capital.
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 number 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 a “return of capital” to the unitholder and reduces the unitholder’s basis in the units.
Typically, 70%–100% of MLP distributions are considered a tax-deferred return of capital, with the remaining portion taxed as ordinary income 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. Upon selling the MLP, investors will pay taxes based on the difference between the sale price and their adjusted basis.
An MLP unit-holder 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. Another convenience of the ETF wrapper, investors who get exposure to MLPs via ETFs do not have to worry about filing state taxes.
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