The Tax Advantages of MLPs

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The Tax Advantages of MLPs

An MLP is a master limited partnership, but the name isn’t as exciting as what it can do in terms of investment.

MLPs are publicly traded partnerships that trade on major stock exchanges like the NYSE or Nasdaq. To be classified as an MLP, it must derive 90% of its revenue from minerals and natural resources, namely exploration, development, mining or production, processing, refining, transportation, and marketing. It may also provide passive income via interest, dividends, and property rent.

The most appealing aspect of MLPs is the partnership’s unique business structure and tax benefits. MLPs are designed under their partnership agreements to transfer the bulk of their cash flow to shareholders known as unitholders. This cash flow is what attracts investors to MLPs. Most partnerships plan what they intend to distribute in cash over the following 12 months, giving unitholders some stability.

Because of the MLP’s unique structure, the partnership does not pay corporate taxes. Unitholders might also benefit from tax breaks. Because the MLP may claim a number of deductions, the partnership’s taxable income is often smaller than the cash flows paid out. This implies that the cash flow received by the unitholder is tax-deferred since it is viewed as a return on capital (though not tax-free).

Tax Implications of MLPs

As an MLP unitholder, you contribute money to the business while receiving cash dividends from continuing operations. As a result, MLPs are a viable alternative for retirees or anybody else seeking a stable income stream.

Distributions are typically tax-deferred since they constitute a return on capital. When you sell, however, you must pay taxes on the difference between the sales price and your adjusted basis.

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For example, if you buy $100,000 in MLP units, you will earn $4,000 in dividends and $3,000 in unit depreciation. You simply need to pay taxes on the difference, which is $1,000. This is true at both the federal and state levels.

While the payouts are good, the return of capital reduces your cost basis. If you hold for a long enough period of time, your basis may ultimately hit zero. After that, all future distributions are taxed as capital gains in the year they are received.

The sale of an MLP may result in a capital gain as well as regular income for the investor. Because cash distributions are attributable to depreciation and other deductions taken by the MLP, such deductions are reclaimed upon unit sale and taxed as ordinary income. Any increase in the value of the units is taxable as a capital gain. Investors must maintain track of their K-1 schedules in order to determine how much is capital gain and how much is regular income.

Fortunately, there is a workaround. If you utilize your MLP for estate planning, you will get primarily tax-deferred income while avoiding a large tax hit on the sale of your MLP units.

This is how it works. You won’t have to pay taxes on a very low-cost basis if you don’t cash out the MLP and instead leave it to a spouse or the next generation (through a will, living trust, or simply transfer on death account) (which will stem from the MLP being held for a long period of time).Even better, your successor will receive the MLP at a greater cost base, which will be readjusted to the market price on the transfer date. This is referred to as a step-up in basis. There will be no capital gains tax if your heir sells the MLP straight away.

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So far, so good, but as you know, there is no such thing as a perfect investment. MLPs, like anything else, have downsides.

Drawbacks of MLPs

Ordinary dividends must be reported on Form 1099-DIV, whereas MLP distributions must be reported on Form K-1. This is a lot more difficult. As a result, your accountant will charge you extra for the labor they must do. This may just cost a few hundred dollars, but depending on the amount of your investment in an MLP, it may quickly add up, since it must be done annually.

Another disadvantage is that many MLPs operate across many states. This implies you’ll have to file in many states. Fortunately, Texas, where there are many MLP prospects, does not have a state income tax. This is also true in Alaska, Wyoming, Nevada, Tennessee, and South Dakota, where there are several MLPs. Florida, Washington, and New Hampshire are also tax-free states.

This isn’t the only downside of investing in a master limited partnership. You may believe that a net loss from MLP units may balance your other revenue, but this is not the case. Any losses must be carried over and used to future earnings from the same MLP. If the losses persist, you cannot deduct them from other income until you sell your MLP units.

Popular MLP Investments

Overall, the benefits of an MLP exceed the drawbacks. This does not ensure success, but it is an investment vehicle to explore due to tax benefits. To begin, two prominent MLP investments on Wall Street are:

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  • Partners in Enterprise Products (EPD)
  • Plains All American Pipeline Company (PAA)

Consider an MLP exchange traded fund (ETF), such as Alerian MLP ETF, if you want to keep things simple yet diversifying (AMLP).MLP firms are represented by the ETF.

The Bottom Line

MLPs are less expensive than conventional business equities since dividends are not taxed twice. In fact, when unitholders get cash distributions, they are not taxed at all, which is highly enticing.

However, the longer an MLP is kept, the more likely the cost basis would decline, increasing the tax liability once units are sold. One option is to include the MLP in your inheritance and leave it to your heirs. Even if you don’t go that route, the cash dividends from an MLP often exceed taxable income.

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