MLPs and Taxes: A Refresher

06/21/2013 7:45 am EST

Focus: MLPS

Roger Conrad

Founder and Chief Editor, Capitalist Times

It's never a bad time to get up to speed on the tax wrinkles, new and old, that investors face with nontraditional plays, writes Roger Conrad of Energy & Income Advisor.

The Energy & Income Advisor team recently attended the National Association of Publicly Traded Partnerships' (NAPTP) annual investor conference. The panelists tackled the one question on all attendees' minds: Will the federal government change MLPs' tax treatment?

The professionals noted that the near-term outlook appears sanguine, citing the jobs created by the US energy sector, the unpopularity of such a move with individual investors, and pending legislation that would allow renewable-energy outfits to structure themselves as MLPs.

Regardless of the legislative risk to MLPs, investors can take some simple steps to gird their portfolios against adverse federal action-or any other black swan.

  • Rule No. 1: Your portfolio's allocation to MLPs shouldn't exceed more than 25% of your investable assets.
  • Rule No. 2: Stick with names that can still thrive even if they're taxed at the corporate level. We would expect most pipeline-owning MLPs to hold their own if Congress were to repeal the structure's tax advantages. Investors should focus on names with lower debt loads, secure revenue streams, and elevated distribution coverage.
  • Rule No. 3: Commit yourself to maintaining a balanced, diversified portfolio. Never allow a single holding to grow out of proportion to the rest of your portfolio. And don't be afraid to take some money off the table in your biggest winners.

For many investors, dealing with the unfamiliar Schedule K-1 instead of the usual Form 1099 is a real headache. But MLPs have worked closely with KPMG and other big accounting firms to simplify the process for do-it-yourself filers to cruise through the process using TurboTax and other popular software programs.

The industry is also making progress disseminating tax material to investors well in advance of April 15. The best source for K-1 information is usually the Web sites of the MLPs you own.

The NAPTP's Web site covers the basic terms and concepts associated with MLP taxation. Here's a refresher course.

MLPs pass through the majority of their profits, losses, and deductions to unitholders who pay personal income taxes on their share of taxable profits. Thereby avoiding the double taxation to which corporate dividends are subject.

Unlike a regular dividend, the IRS considers MLP distributions a return of capital that reduces your cost basis in the MLP, but isn't taxed until you sell your position. At that point, the taxable amount is the difference between your cost basis and the price at sale. The majority of this amount is generally taxed at capital-gains rates.

The portion attributed to "depreciation" and "substantially appreciated inventory and unrealized receivables" is taxed at your ordinary income rate. Starting this year, that tax rate is elevated by the 3.8% surcharge for "investment income."

The NAPTP's Web site also includes an extensive section on holding MLPs in tax-deferred retirement accounts. Investors who hold MLP units in an IRA account don't need a Schedule K-1; the custodian will file a Form 990-T.

In our view, the real drawback of holding an MLP in a tax-advantaged account is the opportunity cost: When you withdraw funds from an IRA, you pay taxes at your regular rate, not the MLP's tax-advantaged rate. We'd argue that the fat returns offered by MLPs are worth the added hassles at tax time.

A word of warning: Investors' top priority should never be tax avoidance. Always focus on names that are well positioned to grow their underlying business and generate superior total returns. Even if you limit your tax burden, a dividend isn't worth much if the company can't at least maintain its quarterly payout.

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