Master Limited Partnerships (MLPs) are unique investments that combine the tax benefits of a limited partnership (LP) with the liquidity of common stock. An MLP has a partnership structure but issues investment units that trade on an exchange like common stock. The modern form of MLPs was defined by the Tax Reform Act of 1986 and the Revenue Act of 1987, which outline how companies can structure their operations to realize certain tax benefits and define which companies are eligible. In order to qualify, a firm must earn 90% of its income through activities or interest and dividend payments relating to natural resources, commodities or real estate.

In this article we'll show you how owning MLPs can help you save on your tax bill.

Tax? What Tax?
Tax implications for MLPs differ significantly from corporations for both the company and its investors. Like other limited partnerships, there is no tax at the company level. This effectively lowers an MLP's cost of capital, as it does not suffer the problem of double taxation on dividends. Companies that are eligible to become MLPs have a strong incentive to do so because it means a cost advantage over their incorporated peers.

In an MLP, instead of paying a corporate income tax, the tax liability of the entity is passed on to its unitholders. Once a year, each investor receives a K-1 statement (similar to a 1099-DIV form) detailing his or her share of the partnership's net income, which is then taxed at the investor's individual tax rate.

One important distinction must be made here: While the MLP's income is passed through to its investors for tax purposes, the actual cash distributions made to unitholders have little to do with the firm's income. Instead, cash distributions are based on the MLP's distributable cash flow (DCF), similar to free cash flow (FCF). Unlike dividends, these distributions are not taxed when they are received; instead, they are considered reductions in the investment's cost basis and create a tax liability that is deferred until the MLP is sold.

Fortunately for investors, MLPs generally have much higher distributable cash flow than they have taxable income. This is a result of significant depreciation and other tax deductions, and is especially true of natural gas and oil pipeline and storage companies, which are the most common businesses to choose an MLP structure. Investors then receive higher cash payments than the amount upon which they are taxed, creating an efficient means of tax deferral. According to a report by Wachovia Securities, titled "Master Limited Partnerships: A Primer" (2003), the taxable income passed on to investors often is only 10-20% of the cash distribution, while the other 80-90% is deemed a return of capital and subtracted from the original cost basis of the initial investment.

Cash Flows and Taxes
Let's look at an example of the mechanics of cash flows and taxes that occur when holding and selling MLPs. Let's assume an MLP is purchased for $25 per share, held for three years, makes cash distributions of $1.50/unit per year and passes through $0.30 of taxable income to each unit per year.

First, we calculate the change in cost basis caused by the net return of capital - cash distributions minus allocation of taxable income - over the life of the investment. For simplicity, assume taxable income and cash distribution remains constant through the life of the investment, although in reality, these probably would fluctuate each year.

-- Year 1 Year 2 Year 3
Cost Basis at Beginning of Year $25.00 $23.80 $22.60
Allocation of Taxable Income $0.30 $0.30 $0.30
Cash Distributions $1.50 $1.50 $1.50
Net Reduction of Cost Basis $1.20 $1.20 $1.20
Adjust Cost Basis at End of Year $23.80 $22.60 $21.40

If the MLP is sold at the end of the third year for $26 per unit, the investor (LP) would show a gain of $4.60. One dollar of this would be a normal capital gain - having bought at $25 and sold at $26 - and would be taxed at the long-term capital gains tax rate. The remaining $3.60 gain results from the $1.20 return of capital each year, and this amount would be taxed at the investor's personal income tax rate. The table below shows cash flows, including those related to taxes, during the life of the investment. We assume a 35% income tax rate and 15% capital gains rate. (To learn more about capital gains, see A Long-Term Mindset Meets Dreaded Capital-Gains Tax and Capital Gains Tax Cuts For Middle Income Investors.)

Cash Flows Year 1 Year 2 Year 3
Purchase of Security -25.00 $23.80 $22.60
Income Tax from Allocation of MLP Income ($0.30x35%) -$0.11 -$0.11 -$0.11
Cash Distributions $1.50 $1.50 $1.50
Sale of Security -- -- $26.00
Capital Gains Tax on Difference Between Purchase Prices and Sale Price -- -- -$0.15
Income Tax on Difference Between Purchase Prise and Adjusted Cost Basis at End of Year 3 ($3.60x35%) -- -- -$1.26
Total: -23.61 $1.39 $25.98

An important side note on the concept of reducing cost basis: If and when the investment's cost basis falls to zero, any cash distribution becomes immediately taxable, rather that being deferred until the sale of the security. This is because the investment cannot fall into a negative cost basis. This can occur if an MLP is held for many years.

MLPs can be used to gain current income while deferring taxes, as seen in the above example. This can be taken one step further when an MLP investment is used as a vehicle for estate planning. When an MLP unitholder dies and the investment is transferred to an heir, the cost basis is reset to the market price on the transfer date, eliminating any accrued tax liability caused by return of capital. (For related reading, see Getting Started On Your Estate Plan.)

Partnership Structure
MLPs contain two business entities: the limited partner and the general partner (GP). The limited partner invests capital into the venture and obtains periodic cash distributions, while the general partner oversees the MLP's operations and receives incentive distributions rights (IDRs). IDRs are structured when the partnership is formed, and provide the GP with performance-based pay for successfully managing the MLP, as measured by cash distributions to the limited partner. Generally, the GP receives a minimum of 2% of the LP distribution, but as payment to LP unitholders increases, the percentage take of the GP through IDRs increases too, often to a maximum of 50%. The table below shows a hypothetical IDR structure outlining the payment split between LP and GP at different distribution levels.

-- LP Distribution Per Unit LP GP
Tier 1 Below $1.00 98% 2%
Tier 2 Between $1.00 and $2.00 80% 20%
Tier 3 Between $2.00 and $3.00 65% 35%
Tier 4 Above $3.00 50% 50%

For each incremental dollar distributed to LP unitholders, the GP realizes higher marginal IDR payments. For example, assuming 1,000 LP units outstanding, if $1,000 is distributed to LP unitholders ($1.00 per unit), then the GP will receive $20 (2% of $1,000). However, if $5,000 is distributed to LP unitholders ($5.00 per unit), then the GP will receive $2,810, as outlined below.

-- LP Distribution GP IDR Level GP Payment Per LP Unit
Tier 1 $1.00 2% $0.02
Tier 2 $1.00 20% $0.25
Tier 3 $1.00 35% $0.54
Tier 4 $2.00 50% $2.00
Total $5.00 -- $2.81
The calculation for the GP\'s payment for each tier is not a straight multiplication of the GP\'s IDR with the LP\'s distribution. The calculation goes as follows:
(LP distribution/LP\'s IDR) x GP IDR
Thus, at the third tier, the GP payment would be ($1/0.65)x0.35 = 0.538 or $0.54

Here we see that the general partner has a significant financial incentive to increase cash distributions to limited partner unitholders; while LP distribution increases 500%, from $1,000 to $5,000, GP distribution increases by more than 14,000%, rising from $20 to $2,810. Note in the calculations in the above table that the IDR payment is not a percentage of the incremental LP distribution amount, but rather a percentage of the total amount distributed at the marginal level. For example, in the third tier, $1.54 is distributed per LP unit; $1.00 (65%) of that amount paid to LP unitholders, $0.54 (35%) paid to the GP.

The corporate structure of MLPs can be more complex than a simple split between the limited and general partnership interests. In some cases, the GP may own LP shares. In other cases, the general partner of an MLP may be publicly traded, and have its own LP/GP split. Or the MLP may have other relationships with additional entities due to financing arrangements. But the most important relationship for the MLP investor to keep in mind is the cash distribution split between LP and GP, and how this will change over time as distributions fluctuate.

Who Should (and Should Not) Own MLPs
MLPs have remained relatively unknown in part because of their low level of institutional ownership and a consequent lack of sell-side attention. Mutual funds were largely restricted from owning them until 2004, but even now, MLPs present a cumbersome investment because funds must send out 1099 forms to their investors detailing income and capital gains in November, but may not receive K-1 statements from MLPs until February. This causes the potential for costly mistakes in estimation.

Tax-exempt institutional investment funds such as pensions, endowments and 401(k) plans are restricted from owning MLPs because the cash distributions received are considered unrelated business taxable income (UBTI) - income that is unrelated to the activity that gives the fund tax-exempt status. This could create a tax liability on any distribution of more than $1,000. This is also true for individuals when holding MLPs in an IRA account; therefore, the best way to hold them is in a regular brokerage account. (To read more about retirement plans and taxes, see IRA Contributions: Deductions and Tax Credits and How IRA Contributions Affect Your Taxes.)

Individual investors are the principal owners of MLPs. Because few individuals know much about their structure and complex tax implications, they are often purchased for individuals by private-client wealth managers, although this need not be the case. As long as the individual - or his or her accountant - understands how to manage the K-1 statement and cash distributions, this investment can be perfect for an investor seeking current income and tax deferral.

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