Master limited partnerships (MLPs) have become an attractive alternative for fixed-income investors who are seeking higher yields, but the tax rules that govern them can provide an unpleasant surprise for clients who fail to read the fine print when they buy into them. MLPs are limited partnerships that are publicly traded and are made up of general and limited partners. The partnership is funded by investments from the limited partners who buy units of the partnership. The limited partners then receive income from the operations of the partnership, while the general partners manage the partnership and are compensated according to their performance.

A Different Animal

MLPs have become the vehicle of choice in the oil and gas sector because of their ability to provide both current income from energy production along with capital appreciation. But while they are usually treated like stocks by investors, they are not taxed like stocks and pass through their income to investors, which is reported on Form K-1. Investors are required to report the income shown on the K-1 on their personal tax returns. MLPs distribute cash to their shareholders in the form of dividends throughout the year, but these dividends are often partially or fully exempt from taxation, depending upon the nature of the income. (For more, see: MLPs: Time to Invest or Has Their Time Passed?)

Income that is generated from oil and gas production often receives special tax treatment, which means that the dividends received by the investors may be exempt from taxation. For this reason, MLPs can therefore provide a solid return on capital with minimal tax liability while the investor owns the units. But the sale of these instruments can yield a substantial tax bill for the investor, because those tax-free dividends are subtracted from the cost basis of the units in the partnership. This means that the investor must report a larger gain on the sale than would otherwise be required. Those who have held their units for long periods of time may see their basis completely eliminated and the entire balance of the sale must be reported as taxable income.

Furthermore, partnerships are not eligible for capital gains treatment, which means that this amount will be taxed as ordinary income at the investor’s top marginal tax bracket. And what makes this especially difficult for investors to deal with is the fact that the amount of dividends that must be recaptured will not be known until the year in which the partnership is sold. But the greater the amount of tax-free income that was received, the greater the amount of taxable income that will be generated from the sale. Unfortunately, the accounting information that the investor needs in order to calculate the amount of recapture beforehand is generally unavailable, which makes tax planning difficult. (For more, see: MLP Investors Hit with Surprise Tax Bill on IRA Income.)

This issue has affected many investors who have sold their shares of energy partnerships during the past couple of years with the decline in oil prices. Some MLPs are considering whether to restructure some of their liabilities in order to improve their cash flow, but investors will realize taxable income equal to the amounts of any debts that are forgiven. Some MLPs have chosen to restructure themselves as C corporations, which protects investors from having to recognize this income.

And IRA investors who seek to avoid taxation by holding shares of MLPs in their IRAs may also be liable for Unrelated Business Income Tax (UBIT). The tax rates for income that is generated from the partnership are the same as for trusts, which have the highest tax rates in the tax code. The 39% tax bracket is reached after receiving a mere $12,400 of income. Not all of the partnership income may be taxable, but investors who intend to receive a substantial amount of income from this type of investment need to be prepared to pay this tax.

The Bottom Line

Despite their tax treatment, MLPs can still be appropriate investments for investors who understand how they work. Many of the weaker offerings in this sector have been liquidated, and those that are left can still provide a competitive return. (For more, see: Pros and Cons of Master Limited Partnerships.)