Should You Invest in MLPs? - Cabot Wealth Network

Should You Invest in MLPs?

You may have been told at some point to invest in MLPs. But what are MLPs exactly? And are you the type of investor who should invest in MLPs? Answering the questions below will help you make that decision.

What Kind of Account Do You Use for Investing?

MLPs (short for master limited partnership) are exempt from U.S. corporate taxes in exchange for passing on most of their income to investors, who are called unitholders. As a result of this unusual situation, unitholders accept the tax burden on the distributions they receive from the MLP. But the distributions are heavily tax-advantaged, with most of your tax burden deferred until you sell the MLP.

However, because the distributions are business income that has not been taxed, the IRS considers MLP distributions paid into an IRA or Roth IRA Unrelated Business Taxable Income, or UBTI. And if your IRA earns over $1,000 in UBTI (total from all sources, including distributions from different MLPs) in a single year, your IRA will be liable for paying tax on that income at corporate tax rates.

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For this reason, it’s generally not a good idea to hold MLPs in an IRA or Roth IRA.

Does the Tax Burden Make Sense for You?

As mentioned above, MLP distributions do come with a tax burden, although most of it is deferred until you sell the MLP.

When you receive distributions from an MLP, you only owe taxes on the portion of your distribution that came from the MLP’s net income—which the MLP will inform you of in an annual form called a K-1. It’s usually between 10% and 20% of the distribution. You then have to pay regular income taxes (not the lower qualified dividend tax rate) on that portion of the distribution.

The other 80% to 90% of the distribution is considered Return of Capital. Return of capital is not considered income; instead, it’s treated as if the MLP is simply giving you back some of the money you’ve invested in it. As such, you’re not taxed on this portion of the distribution. Instead, it reduces your cost basis in the MLP.

When you sell the MLP, you will have to pay taxes, at your regular income tax rate, on the difference between your original purchase price and your reduced cost basis.

Let’s say you buy an MLP for $50 per share, and your distributions that qualify as return of capital average $2 per share every year. If you decide to sell the MLP after 15 years, your cost basis per share will be $20 (or $50-[$2 x 15 years]). You now owe income taxes on the $30 difference between your adjusted cost basis per share and your original price.

So if you’re happy collecting tax-free income now and owing taxes later, MLPs may be for you. But they aren’t appropriate for investors who aren’t prepared to deal with that tax bill upon selling.

There is a perk for investors who plan to pass some of their investments on to their heirs. For tax purposes, the cost basis of MLP units is “reset” to the current market value if the original unitholder dies and passes on the investment. So the new owner won’t owe income tax on the difference between the original cost basis and the adjusted cost basis.

Do You Mind Doing the Paperwork to Invest in MLPs?

Owning MLPs does incur a little extra work at tax time. MLPs issue tax forms called K-1s instead of 1099-DIVs, and many investors prefer to avoid them. The K-1 tells you what percentage of your distribution was return of capital and lists your pro-rata share of each income and expense item of the partnership. The form should also provide you all the information you need to enter this information into your taxes. (You likely will report these items on Schedule E, instead of the Schedule B where payouts from stocks, bonds and mutual funds are reported.) Some MLPs even allow you to download the data directly from your K-1 into your tax preparation software.

Most accountants can handle K-1s and some MLPs have helpful investor relations contacts, but it’s worth considering whether you want the hassle.

In addition, if your state has an income tax, it likely will require you to either complete similar state versions of the form or attach a copy of the federal forms to your state return.

Do you own any MLPs currently? Tell us which ones and how they’re performing.

Chris Preston

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Investment analyst and Chief Analyst of Cabot Wealth Daily, Chris Preston brings you all the latest from the investing world. Sign up to get updates and breaking news delivered FREE to your inbox. Get unlimited access to our library of complimentary investing reports.

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