Master limited partnerships, or MLPs, are a unique type of business allowed under the U.S. tax code. They’re similar to a “regular” limited partnership, with a few differences.
In addition to a limited partner or partners, who provide the MLP with capital and get a share of its cash flow in return, they also have a general partner that runs the business.
In addition, MLPs are publicly traded, by definition. The limited partners are the public shareholders—in this case called unitholders.
The primary benefit of being organized as an MLP is that the business doesn’t pay corporate taxes on its revenue. Instead the cash flow is distributed, almost entirely, to the unitholders (who are then responsible for taxes).
That makes MLPs a very efficient way to pass along the cash flow of an income-generating enterprise to public shareholders. And so they often make large regular distributions, and have very high yields.
Not just any business can be organized as an MLP though. The tax code requires MLPs to derive about 90% of their revenue from natural resources, commodities or real estate. In practice, many own energy transportation or processing facilities, like oil or gas pipelines.
While they’ve become much more popular in these years of rock-bottom interest rates, most investors still have a lot of questions about MLPs, and specifically, how they are taxed on their MLP holdings.
How do I pay taxes on my distributions from MLPs?
Because MLPs don’t pay taxes at the corporate level, you will owe tax on any MLP distributions you earn. But the distributions are heavily tax-advantaged, with most of your tax burden deferred until you sell the MLP. Here’s how it works.
MLP distributions are made based on the MLP’s distributable cash flow (DCF), which is similar to free cash flow (FCF).
This is important because a partnership’s DCF is usually much higher than its net income. That’s because MLPs have significant depreciation and other tax deductions, which lower their taxable net income significantly. (This is why certain types of businesses make better MLPs: huge tangible assets like oil pipelines have very high depreciation expenses.)
So the money comes in, the MLP pays it out as distributions to you and the other unitholders, then the MLP takes deductions on the amount and reports its taxable net income to the government.
And, as you may have guessed, 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.
You do have to pay regular income taxes on that portion of the distribution (not the lower qualified dividend tax rate), but it’s usually only 10% to 20% of the total distribution.
What happens to the other 80% to 90% of the distribution?
The other 80% to 90% of the distribution is considered “return of capital,” and reduces your cost basis in the MLP.
So if you buy a unit for $50, and receive an annual distribution in your first year of $3.50, of which $0.30 is considered taxable net income, your cost basis in the investment will be reduced by $3.20 (the distribution minus the portion of the distribution that is net income), to $46.80.
You do have to pay regular income taxes on the difference between your original purchase price and your reduced cost basis when you sell the MLP (at the same time you pay taxes on your capital gains), but in the meantime, those taxes are deferred.
That’s a big benefit to many investors who want to focus on reducing their current tax liability on their investment income (because they’re living off it, or for other reasons). Plus, the cost basis of the investment is “reset” to the current market value if the original unitholder dies and passes on the investment. So the new owner won’t owe tax on the difference between the original cost basis and the adjusted cost basis.
*This post has been updated from a previously published version.