Basic Tax Principles
Owning units (shares) in an MLP is different from owning corporate stock in a number of ways, most notably their taxation. That is because an MLP is a partnership, and you, as an investor, are a limited partner. To understand how an MLP investor is taxed, it helps to know the basic principles of partnership taxation.
Partnership Tax Basics: Income
- An MLP, like all partnerships, is a pass-though entity which pays no tax itself. It is treated by the tax code not as a separate entity but as a collection of partners.
- The unitholder, as a limited partner, is treated for tax purposes as if he is directly earning his share of the MLP’s income.
- Each unitholder is allocated on paper a proportionate share of the MLP’s income, gain, deductions, losses, and credits. This is reported annually on the K-1 form.
- The unitholder enters these items on his tax return and pays tax on the net income at his own tax rate. The tax is owed whether or not the unitholder receives a cash distribution.
- If there is a net loss, it cannot be used to offset the unitholder’s other income. It must be carried forward and used against future income from the same MLP. Any loss still remaining may be deducted against other income when the unitholder sells his entire interest in the MLP.
Partnership Tax Basics: Distributions
- The quarterly cash distributions are not the same as your share of the MLP’s income.
- Under the tax code, the distributions are a return of capital and are not taxed when received.
- Your basis in your partnership units (the amount you paid, increased or decreased by various adjustments) is lowered by the amount of the distribution.
- Thus, when you sell your units, your taxable gain (sales price minus adjusted basis) is increased by the amount of the distributions.
- Often you will hear someone say that “80% (or a similar number) of the MLP’s distribution is tax-deferred.” As long as your distribution is less than your basis, it is 100% tax-deferred. What they mean is that your share of the MLP’s net taxable income equals about 20% of the tax-deferred cash distribution.
Partnership Tax Basics: Basis Adjustments
- Basis is used to determine your gain or loss when you sell your units.
- Your initial basis is the price you paid for your units.
- Your cash distributions adjust your basis downwards.
- Your share of taxable partnership income each year adjusts the basis upwards.
- Your share of deductions like depreciation adjusts it downwards. Or in other words, your basis is adjusted upwards by your share of income minus your share of deductions.
- As long as your adjusted basis is above zero, tax on your distributions is deferred until you sell your units. If it reaches zero, future cash distributions will be taxed as capital gain in the year received.
- If a unitholder dies and the units pass to his heirs, the basis is reset to the fair market value of the units on the date of death, and the prior distributions are not taxed.
Partnership Tax Basics: Gain and Recapture
- When you sell your MLP units, your taxable gain is the difference between the sales price and your adjusted basis.
- Not all of the gain when units are sold is taxed at capital gains rates.
- The gain resulting from basis reductions due to depreciation is taxed at ordinary income rates—this is called “recapture.”
- Gain attributable to your share of some types of assets held by the MLP—substantially appreciated inventory and unrealized receivables—is also taxed as ordinary income.
- These items will be reported to you on the K-1 form for the year in which you sell your units.
Year 1: 1,000 units purchased @ $30.00. Basis is:
Investor receives total cash distributions of $2.50/unit
Investor is allocated and pays tax on net taxable income of $.50/unit, including $2.00 of income and $1.50 of depreciation
+ $ 500
Year 2: All units sold @ $32.00
Gain per unit: $32.00 – $28.00 = $4.00
Depreciation recapture-taxed at ordinary income rates
Taxed at capital gain rates*
*Assumes MLP has no "ordinary income" assets
This fact sheet is for informational purposes only and should not be construed as offering tax advice. Consult your tax advisor regarding your own situation.