Once relegated to a sleepy backwater of the investment landscape, Master Limited Partnerships, or MLPs, have gained in popularity among investors seeking income in a low-yield world. Many investors will greet a new tax season holding these investments for the first time, so a brief primer on their taxation may be in order.
Technically called Publicly Traded Partnerships, these securities were originally created as a vehicle for raising capital from individual investors to finance infrastructure assets necessary for the extraction and refining of critical natural resources. Like other businesses organized as partnerships, MLPs are "pass-through" entities that don't pay corporate income taxes but pass profits and losses to individual partners. The MLP structure allows individuals to purchase shares in the company (known as units) on public stock exchanges, providing essential liquidity to a broad class of investors for whom non-traded partnerships are generally inappropriate.
The first publicly traded partnership, Apache Oil Company, appeared in 1981. The structure got off to a fast start as firms raced to grab the tax benefits of the public partnership format. By the mid-1980s, the MLP form of organization extended to a panoply of divergent businesses, including sports franchises like the Boston Celtics. Congress, compelled to restrict their proliferation, passed legislation in 1987 limiting public partnerships to specific activities related to resource extraction, processing and transportation.
Today there are over 100 listed MLPs with $720 billion in investor assets, concentrated most heavily in the mid-stream activities of storage and transportation via pipelines, although extraction and ocean transport also are well represented.
Investors who own an MLP in a taxable investment account for the first time soon discover a difference in how their tax information arrives. Instead of the familiar form 1099 generated by their broker, unitholders receive a partnership report known as form K-1 directly from the MLP. Cash distributions as well as the partner's share of income and losses are all reported on the K-1 for use in preparing the investor's tax return. While including partnership interests on your tax return adds a level of complexity, the additional effort can be worthwhile given the tax efficiency of the cash distributions. Popular tax preparation software facilitates the inclusion of K-1s quite easily. And of course the easiest method is to tie a bow around them and hand them to your tax preparer. Be sure to smile.
Partnership interests held in an IRA or other tax-sheltered account present additional complications, but should not be seen as prohibitive. Certain investments including limited partnerships may actually generate a tax liability even inside an IRA account, since partnerships that pass through income also pass through tax liability. The good news is that the reporting is not your problem.
The responsibility for reporting any tax rests with your brokerage firm or custodian. Investors who receive K-1s for holdings in their IRA merely submit the forms to the custodian, who then reviews them and if necessary files a report of "unrelated business income" on IRS form 990-T. Any tax due is withdrawn from your account and remitted to the IRS by your custodian. The payment is not considered a withdrawal for tax purposes.
Note however that such tax liabilities are rare, since many MLPs report net losses but distribute cash payments as a return of principal. And losses may be carried forward to offset future income from the same MLP.
It is not unusual for K-1 forms to run late into the tax filing season, and may occasionally be tardy enough to require filing an extension. But the benefits may well justify the extra effort.
Christopher A. Hopkins, CFA, is a vice president and porfolio manager for Barnett & Co.