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How are Master Limited Partnership (MLP) Dividends Taxed?

For the last few years, I’ve started investing in blue chip companies that offer nice dividends, as an alternative to high yield savings accounts [3] (not a replacement alternative, more like a much riskier alternative), and one type of company I’ve stayed away from has been Master Limited Partnerships. I knew that taxes were going to be trickier with MLPs and I did some brief reading, enough to know it was trickier than simple reporting, but now I want to know more.

Today, we’ll describe what an MLP is, how it differs from a “regular” company, and the tax considerations when you invest in one.

What is a Master Limited Partnership?

A Master Limited Partnership (MLP) is a type of corporate structure (limited partnership) that can be publicly traded. In the United States, MLPs are limited to only certain enterprises, usually one in which the business generates at least 90% of its income from “qualifying sources” according to the IRS. Usually that qualifying resource is a natural resource (oil, gas, etc.) of some kind. The significance of a partnership, rather than a corporation, is that the income passes through the company and directly to its shareholders, or partners, and so they are not taxed at the corporate level. Logistically, there is one general partner, who runs the business, and several limited partners, which are typically the shareholders.

As a limited partner, you are theoretically liable for the obligations of the MLP you’ve invested in. That’s a potential risk but one that has never been realized (but still important to be aware of).

How are the payments taxed?

When you own shares of a “regular” corporation, say Duke Energy Corporation [4] (I own shares of Duke Energy), and it’s yielding 4.69%, the taxes are straightforward. Every quarter, they send me 77 cents per share and at the end of the year, I get a 1099-DIV from my brokerage firm and I report that as dividend income on Schedule B of my tax return. Very simple.

Let’s say I own shares of Kinder Morgan Energy Partners [5] (I don’t own any but I might in the future), a very well known MLP that has a yield of 5.72%. Every quarter they send me $1.23 a share (it varies) but I don’t necessarily check a 1099-DIV (in fact, they’re not technically dividends at all – it’s taxed at ordinary income rates) and put the entirety into Schedule B. That’s because it’s considered income, not dividends, and you get to claim depreciation charges, which can defer your tax liability on the payments.

With MLPs, you’re a limited partner in the business and this is a business with lots of capital equipment. Kinder Morgan is a pipeline transportation and energy storage company – they have a lot of heavy equipment and infrastructure that they already paid for and now get to depreciate. As a limited partner, you get to offset some of your income with those depreciation charges.

Schedule K-1
What you’ll get is a Schedule K-1 and that’s a much more complicated form than a 1099-DIV (it will often come later too, it’s not subject to the same January 31st deadline and since the K-1 is based on the tax return of the company, might come a lot later). That form will outline all the various adjustments you’ll make (such as depreciation and depletion expenses) for your taxes and creates a bit of a tax filing headache for you or your accountant. So the depreciation expense will offset some of the income but you will reduce your cost basis by that same amount, because you’ll need to recapture that depreciation when you sell your shares (ownership stake). When you sell, that difference is taxed at long term capital gains as long as you’ve owned the shares for more than one year.

Also, and this is a big killer in my mind, the K-1 will outline taxable income by state and you may be required to file a state income tax return in every state where the MLP operates. That depends on the state but represents a potentially huge headache.

One thing to watch out for if you’re considering buying one in a retirement account like an IRA, if the MLP’s unrelated business taxable income (UBTI) exceeds $1,000 in a year, the income may be taxable.

An Example
Let’s take a simple example – you bought shares of an MLP that owns a pipeline for $20,000. Income from your share of the pipeline is $1,000 a year. The MLP owns some equipment it uses to service that pipeline and that results in a depreciation expense of $800 a year for you. This year, you will get $1,000 in cash and then claim $800 in depreciation expenses, so you owe ordinary income taxes on just $200 of the $1000 that you received. Your cost basis in the company is now reduced by $800, so really you’re $20,000 stake is now just $19,200. If you were to sell your stake for $21,000 in a year, then you’d owe long term capital gains taxes on a gain of $1,800 because of the reduced tax basis.

As you can see, the appeal of MLPs isn’t in the favored tax rate on the regular payments (you don’t get dividend tax rates on those payments, it’s ordinary tax rates), it’s that you get a return of some of your capital tax free (the depreciation amount). You have to pay that back, when you sell the shares, but until then you still have the same ownership stake but you have less capital tied up in the investment.

Whew… I hope that partially (and accurately!) explains how taxes with an MLP work and how they’re different than your traditional dividend play type of companies. At the moment I’m still staying away from them, the more complicated taxes are not something I look forward to, but if you have some, I’d love to hear your experiences with that.

(Photo: mikebaird [6])