Low interest rates continue to cause income-oriented investors to search for alternatives to traditional bond investments. One such option has been master limited partnerships, or MLPs. While MLPs have their attractive features, investors are discovering that the tax consequences of these investments may be more than they had bargained for.
MLPs have long been a popular way to invest in oil and gas businesses because of their combination of cash distributions and opportunity for appreciation. Even though MLPs are often referred to as stocks and are traded like stocks, they are treated as partnerships for tax purposes.
Partnerships are generally not subject to tax, but instead issue each investor a Schedule K-1 that shows their share of the MLP's income. Income reported on the K-1 is taxable to each investor and is reported on their personal tax return.
During the year, MLPs make cash distributions to their shareholders out of the revenue from their business. These distributions are often referred to as dividends, but bear little resemblance to what we traditionally consider dividends — primarily because these distributions are not necessarily taxable. Unique deductions available to oil and gas investments allow them to offset their revenue for tax purposes. As a result, the K-1 may reflect little to no taxable income despite the MLP making regular distributions. Therefore, MLPs can offer the perfect combination — attractive cash flow with little tax consequences. That is, until the MLP is sold.
SELLING AN MLP
The decline in oil prices since 2014 has caused the less-resilient MLPs to fall out of favor, leading investors to sell their positions. Those investors are now realizing that those tax-free “dividends” are treated as a reduction in their cost basis. Investors holding an MLP long enough have seen their cost basis significantly reduced and nearly eliminated. What makes that reduced basis even worse is the tax treatment of the gain upon sale.
The sale of an MLP triggers a recapture of those deductions that allowed the distributions to be tax-free in the first place. Instead of a capital gain upon the sale of the MLP, that recaptured amount is taxed as ordinary income, and the cost can be significant. In extreme cases, the entire gain might be taxed as ordinary income.
The trickiest part of this is that the recapture amount is unknown by the investor until it's reported on the K-1 issued in the year the MLP is sold. In general, the bigger the difference between the annual distributions and the income on the K-1, the more recapture income to recognize. However, the details needed to accurately calculate the recapture are unavailable to the investor.
CANCELLATION OF DEBT INCOME
The financial struggles of some MLPs have prompted them to look at restructuring their debt, although doing so can result in investors recognizing income to the extent any debt is forgiven. This cancellation of debt income is also taxed as ordinary income, a double-whammy for investors already seeing a sharp decline in the value of the MLP itself.
To avoid the CODI for their investors, some MLPs have restructured as C corporations. Doing so protects their investors from having to recognize CODI, with it instead being taxable to the C Corp. entity itself. This restructuring is considered a sale of the MLP units, though, which brings the investor back to the recapture issues discussed earlier.
UNRELATED BUSINESS INCOME TAX
One strategy some investors have tried as a way to manage these tax issues is to hold MLPs inside their individual retirement account. Unfortunately, these investors have learned a new four-letter word — UBIT, or Unrelated Business Income Tax. This is a tax on income earned inside an IRA, and it can be surprisingly expensive. While not all MLP income is subject to the tax, the portion that is taxable is subject to the trust tax rates — which reach 39.6% at just $12,400 of income.
KNOW WHAT YOU'RE INVESTING IN
Despite all this, MLPs can still have a place in portfolios, and many of the weaker MLPs have gone away, leaving an overall stronger field of options. As with all investments, it's important that your clients fully understand the tax implications and overall risk profile of what they're buying.
Tim Steffen is director of financial planning for Robert W. Baird & Co. Follow him on Twitter .