The Tax Trap of Master Limited Partnerships

5/1/2013 - By Glenn Scharf, CPA

I find that many of my clients who have investment advisors, are quite frequently invested in Master Limited Partnerships. Some of the names you might recognize are Buckeye Partners or Enterprise Products Partners, but there are many of them. As I am not giving any investment advice on whether you should own these types of vehicles or not, there are some things that you should know from a tax perspective about investing in these vehicles.

First and foremost, you need to understand what you are buying. They are not stocks in Corporations. You are buying units in a Partnership. Therefore, all of the partnership rules apply. You will get what is called a K-1 after the year end tax return for the partnership is completed. This K-1 has amounts of income or losses that are allocated to you. These amounts are reported on your individual income tax returns, so you must wait to file your individual return until the K-1's are produced.

Sometimes these K-1's are produced after April 15th so you may need to extend your own tax return. Losses are considered passive income and could be limited on your return most likely until you sell the interest or you have other passive income. In addition to including this income or loss on your Federal income tax return, you may be required to file tax returns in certain states that you would otherwise not have to file in. This can be a very costly exercise at tax time and you should expect a higher fee from your CPA just for all the reporting requirements that are required.

So here is the big tax trap that I see with these. Since they are partnerships, unlike a normal stock, the basis of your investment is not what you originally paid for the investment. Your basis increases with and income and decreases with any losses or distributions that you receive. The distribution received from the company is not a dividend and is not taxable to the extent it does not exceed your basis in the partnership. Here is an example:

If you originally purchase an MLP for $10,000, that would be your original cost. After a couple of year you have a $500 cumulative loss from your K-1 and you received distributions of $1,000. Your basis is now reduced to $8,500. So if you sell the investment for $11,000 you will have a gain of $2,500 and not $1,000 that most likely is what is on your 1099 from your broker.

Another special item about these MLP's is that a special section of the internal revenue code (Section 751) comes into play when you sell them. In a partnership if you have certain assets in the partnership that have appreciated some of your transaction will be reclassified as an ordinary gain.

To further the example above, without Section 751 you would have a capital gain of $2,500. However, with Section 751, the partnership informs you that $1200 of your gain should be reclassified as ordinary income. So instead of having all the gain be at a favorable 20% rate, now you have $1,300 as capital and $1,200 as ordinary.

Some say this is not such a big deal but it can be in certain circumstances. If for example your investment calculates at a loss this can be very problematic. If you originally purchase an MLP for $10,000, that would be your original cost. After year end you receive your 2013 K-1 and you have a $500 gain and received no distribution. Your basis is now $10,500. If you sell the investment for $10.000 you have a $500 potential loss. However, if you have a 751 adjustment that says you must recognize $1,200 as ordinary income, instead of a $500 loss you now have a $1,700 capital loss. So the $1,200 ordinary income and the $1,700 capital loss net to your $500 loss but the character of the components is important. If you are in a situation where you have capital loss carryovers in your return, you would not be able to use the $1,700 capital loss but you would still have to recognize the $1,200 of ordinary income. And that is the tax trap of the MLP. Once again your accountant has to do a lot of work related to this and you should expect a higher cost of preparation of your tax return.

So how do we cure this? Well if you do not want to recognize ordinary income and you don't want the higher cost of tax preparation, own the MLP in a tax deferred account like an IRA. This way there is no reporting on your tax return and no additional costs to prepare your return. As a final note, if you are investing in these MLP's the administrative cost of owning them may far outweigh the benefits from an investment standpoint. In other words, unless you are going to make a significant investment in these vehicles (above $50,000), the administrative cost for your tax return may outweigh the gains you may receive in the investment.

Talk to your investment advisor or contact us at Saltmarsh at (800) 477-7458 for more about what kind of return you are going to expect for what you have invested to see if it is worth it.

- Glenn Scharf, CPA