The Risks and Rewards of Investing in Master Limited Partnerships by Jeffrey M. Mutnik, CPA/PFS
Over the past decade, master limited partnerships (MLPs) have increased in favor among savvy investors, thanks to historically strong returns and steady income they provide in a low-yield environment. However, these crafty investments often come with complicated compliance requirements and surprising tax liabilities.
What is an MLP?
A master limited partnership (MLP) is a business that trades its equity shares in a public exchange and avoids corporate taxes by using a limited partnership structure. It is required to periodically distribute much of its tax-advantaged income to its owners, also known as its limited partners. With the majority of MLPs operating in the traditionally stable energy and natural resource industry, they have provided their limited partners with steady and predictable returns. In fact, the S&P MLP Index returned 28 percent annually from 2009 to 2014, compared with 22 percent for the S&P 500.
Despite these benefits, MLPs come with a series of tax reporting, compliance and liability complexities, which, at times, can amount to more than the gains the investments generate.
How are Investors Taxed on MLPs?
The pass-through structure of an MLP shields it from entity-level corporate taxes while enabling it to distribute a larger percentage of cash flow to investors. These distributions represent a return on investor’s capital, for which investors may defer much of the related taxes until the interest is sold. However, with the protection MLPs receive as partnership entities, they ultimately pass onto investors the tax liabilities of all of their activities, including income, gains, losses and credits. These activities also affect investors’ tax basis, or the amount they paid for shares in the MLP, plus or minus adjustments. Generally, each distribution decreases the basis of the investment. In turn, the lower basis will have tax implications upon the sale of the interest. Further, as a partnership interest for tax purposes, the partner/investor is subject to all of the complicated partnership rules, which can include distributions in excess of basis, depreciation recapture, “hot asset” taxation, “step up” or “step down” at the death of the partner, and others.
Another surprise for many investors is the way in which MLPs report their activities. Rather than sending out 1099s that report earnings during a tax year, MLPs issue partnership K-1s that detail all of their underlying activities, which investors must report on their personal tax returns. Unitholders who anticipated their investments would yield tax-free cash flow are often startled by the resulting taxes on their share of the MLP’s profits. Operating losses incurred are limited in their usefulness, as they must be suspended until the same activity generates income in a future period or until there is a disposition of the investment. Moreover, many MLPs operate in multiple taxing jurisdictions. Therefore, investors may meet filing thresholds in some or dozens of states, requiring the filing of individual nonresident income tax returns in those states. As a result, the compliance costs an investor may incur could alone mitigate any income earned from the MLP.
How Can I Limit My Risk?
Portfolio diversification is the most basic tenet of managing investment risk. Many investors and/or their investment managers desire exposure to a particular sector of the economy that MLPs can provide. However, using these vehicles may create unintended tax consequences. Therefore, the first step in managing risks associated with MLPs is to determine if these types of investments are appropriate for a portfolio. Do the potential gains outweigh the federal and state tax compliance costs?
Should an investor be undeterred by MLP risk and opt to hold onto the investment in search of high yield and enhanced returns, he or she should meet with an experienced accountant to assess and offer solutions for managing the multitude of tax liabilities and compliance issues that MLP’s demand. If the combination of risk and cost are too great, the best suggestion is to meet with an investment advisor to identify alternatives for generating similar yield without taking on similar risk.
About the Author: Jeffrey M. Mutnik, CPA/PFS, is a director with the Taxation and Financial Services practice of Berkowitz Pollack Brant Advisors and Accountants. He can be reached in the CPA firm’s Ft. Lauderdale office at (954) 712-7000 or via email at firstname.lastname@example.org.