Summary
- MLPs are pass-through entities that enjoy special tax treatment. As pass-through entities, MLPs avoid the double taxation associated with investments in C-Corporations.
- Typically, 70-100% of MLP distributions have been considered a tax-deferred return of capital, which means one does not pay taxes on that portion of the distribution until the investor sells his or her position.
- Basis is very important for MLP investing as different items can increase and lower basis over time.
Many investors understand that MLPs provide income, but only a smaller subset are familiar with the tax advantages of MLP income. In a survey of over 600 financial advisors conducted in 4Q21, almost 80% of respondents recognized MLPs as income investments but only 22% indicated that they were very familiar with the tax advantages of MLP investing. Today’s note provides a refresher course on the tax advantages of directly investing in MLPs. VettaFi is not an accounting firm or tax consultant, and this piece does not constitute tax advice. For details specific to your situation and investment, please consult your tax advisor.
The Basics of MLP Taxation
MLPs are pass-through entities that enjoy special tax treatment. MLPs do not pay taxes at the entity level if 90% or more of their income is from qualifying sources, which include production, processing, transportation, and other activities involving minerals and natural resources. For tax purposes, MLP investors, called unitholders, are treated as if they are directly earning their portion of the MLP’s income. Each year, unitholders are allocated their share of an MLP’s income, deductions, credits, and other items on a Schedule K-1 that is used for filing taxes. Unitholders pay taxes on any net income allocated to them at their individual tax rate. The pass-through nature of MLPs also applies to state-level taxes, which means MLP investors may have to pay state income taxes in states where the MLP operates. Some states do not require state tax returns unless your gross income exceeds a certain threshold, which could result in fewer state filing requirements. As pass-through entities, MLPs avoid the double taxation associated with investments in C-Corporations (corporation pays taxes and investor pays taxes on dividends and capital gains).
MLP Distributions Are Largely Tax-Deferred
MLPs have historically paid attractive dividends, called distributions. Distributions typically exceed the net income allocated to the unitholder. The difference between the distributions received and the net income allocated to the unitholder is treated as a tax-deferred return of capital. Typically, 70-100% of MLP distributions have been considered a tax-deferred return of capital, which means one does not pay taxes on that portion of the distribution until the investor sells his or her position (read more). Any portion of the distribution that is not considered a tax-deferred return of capital will be taxed as ordinary income. The Tax Cuts and Jobs Act of 2017 included a 20% deduction for qualified business income (QBI) from pass-throughs, including MLPs. For someone in the highest tax bracket of 37% who receives the full 20% QBI deduction, the effective tax rate on net income would be 29.6% (excluding the 3.8% Medicare tax).
The example below provides helpful context. In this example, an investor receives a total distribution of $100 that is 80% tax-deferred return of capital. The investor will not pay taxes on the $80 until the MLP position is sold. With the QBI deduction, the investor pays just $5.92 on the remaining $20 as shown in the table below, which equates to an effective tax rate of 29.6% ($20 x .296 = $5.92).
Understanding Basis Adjustments for MLPs and Recapture
Basis is very important for MLP investing and can often be a point of confusion for investors. Basis determines the gain or loss on an investment, and the taxes owed on gains. When investors buy an MLP, their initial basis is the price paid. Distributions are not taxed when they are received but lower an investor’s basis. Income increases an investor’s basis, and MLP unitholders pay taxes on their portion of the partnership’s income. (As discussed above, distributions and income are essentially netted when distributions are described as a percentage return of capital.) As long as an investor’s basis is above zero, the return of capital portion of distributions is tax deferred until units are sold. However, if an investor’s basis falls below zero, future distributions are taxed as capital gains in the year they are received.
The tax treatment for MLP units upon sale can be confusing in part because gains may be taxed at different rates. When units are sold, gains from basis reductions are taxed at ordinary income rates with the 20% QBI deduction discussed above. This is referred to as “recapture.” Any additional gains are taxed as capital gains. The example below shows how basis is adjusted and tax treatment at sale. In the example, the investor would pay capital gains taxes on $200 and ordinary income taxes on $64, which incorporates the 20% QBI deduction.
Other MLP Tax Nuances – Estate Planning, Foreign Investors, and Tax-Advantaged Accounts
The potential for tax-deferred income and related basis adjustments are key to understanding MLP taxation, but there are a few other nuances to direct investment in MLPs. MLPs can be attractive as an estate planning tool, because basis is stepped up to fair market value for heirs on the date of death, thus avoiding the taxes on basis reductions (recapture). Owning an individual MLP in a tax-advantaged account could result in Unrelated Business Income Tax if Unrelated Business Taxable Income (UBTI) exceeds $1,000 in a given year (read more). Investors that own MLP ETFs in a tax-advantaged account do not need to worry about UBTI. Finally, MLPs provide tax advantages for US investors, but for foreign investors, MLPs are required to withhold taxes from the distributions at the highest individual tax rate. In recent weeks, MLPs have announced the availability of Schedule K-3 tax packages that reflect items of international tax relevance, which would primarily be used by foreign unitholders.
Bottom Line:
MLP’s tax advantages – the potential for tax-deferred income and the avoidance of double taxation – come with some nuances, but the benefits arguably outweigh the complexity.
Next week’s piece will focus on the tax treatment for MLP-focused investment products.
Related Research:
Income Opportunities: MLPs, CEFs, and Return of Capital