Making sense of the tax benefits of Master Limited Partnerships (MLPs)
Master Limited Partnerships (MLPs) are a popular equity class due to their high yields, stable cash flow, and exposure to America’s growing energy industry. They also offer important tax benefits, which were enhanced as a result of the 2017 Tax Cuts and Jobs Act.
This brief highlights several MLP tax issues so that you can better determine whether or not this asset class is appropriate for your goals of achieving greater portfolio diversification and generating attractive tax-advantaged dividends.
The important differences between MLPs and dividend-paying stocks
As you know, individual stocks are in publicly traded C corporations and pay dividends to shareholders at the discretion of the company’s board of directors. C corps operate in a variety of businesses.
MLPs, on the other hand, must “pass through” most of their cash flow, as well as their tax obligations, to their investors, who are called unit holders versus shareholders. What’s more, MLPs are required to generate at least 90% of their income from natural resources such as oil or gas, or the storage, transportation, or processing of these resources.
The chart below summarizes the major differences between corporations and MLPs.
Source: Motley Fool
Under the traditional MLP business model, most MLPs don’t have employees. Instead they have management teams provided by their general partner or sponsor.
The sponsor typically owns a 2% general partner stake in the business, a substantial amount of limited partnership units (which is what individual investors own), and the incentive distribution rights (IDRs).
IDRs create an incentive to grow the distribution quickly by selling (“dropping down”) assets to the MLP to grow its cash flow and thus its payout.In other words, from the perspective of the sponsor, MLPs are a tax-efficient method of monetizing natural-resource-based assets (such as pipelines and energy storage and processing terminals) while still benefiting from their stable cash flow.
From the perspective of individual investors, MLPs are a source of generous and growing income, underpinned by relatively commodity-insensitive cash flow.
Tax benefits offered by MLPs
#1. No double taxation
Thanks to the way MLPs are structured, the MLP itself usually doesn’t pay corporate taxes. These entities avoid the standard double taxation problem that regular C corps have, in which a company pays tax on its net income that funds the dividend, and then investors have to pay their own tax on that dividend.
#2 Attractive rules for depreciation
MLPs’ tax benefit is due to the large amount of depreciation created by the capital-intensive nature of the industry in which they operate.
The 2017 Tax Cuts and Jobs Act granted MLPs the ability to expense 100% of their construction costs for projects through 2022. This is more than double the percentage allowed under accelerated depreciation rules.
Further, when an MLP acquires assets or another MLP entirely, it can now step up the value of those assets. This means it can reset the value of those assets to what it paid for them (including the premium paid when acquiring a rival MLP), and provides the added benefit of additional depreciation write-offs against any corporate tax liabilities. This is another change that arose from the 2017 Tax Cuts and Jobs Act.
#3. Favorable ROC classification of distributions
Under IRS rules, the majority of an MLP’s distributions are considered a “return of capital” (ROC). This means the IRS treats the distribution as if the company is simply taking the cash that investors gave the MLP (when it sold more shares to raise capital) and giving it back to them.
Rather than pay taxes on this ROC, this portion of the distribution is simply deducted from the unit holder’s cost basis. If a unit holder’s cost basis reaches zero, then any future distributions are taxed as long-term capital gains.
Here’s how long-term capital gains tax rates look as a result of the 2017 Tax Cuts and Jobs Act:
Example of favorable tax treatment
Suppose someone purchased an MLP at $10 per unit, and it paid $1.00 in an annual distribution, 80 cents of which is classified as a ROC.
That 80 cents per unit in distribution is not taxed, but rather deducted from the unit holder’s cost basis, which is now $10.00 – $0.80 = $9.20 per unit.
At a later date, the unit holder sold the MLP at $11 per unit. The tax liability would be this person’s capital gains tax rate applied to the $1.80 per unit. This is the difference between the cost basis of $9.20 and your $11 selling price.
Consider this …
If the MLP is bought out by a C corp (which has occurred several times since the oil crash), then this buyout is considered a taxable event. As a result, the unit holder must pay all deferred taxes accrued over their investment period.
And consider this as well …
What if the unit holder never sells his or her units? Eventually the unit holder might be able to reduce the cost basis to zero, at which point all future distributions would be taxed at long-term capital gains rates (effectively like qualified dividends).
Treatment at death
An often-overlooked benefit to ROC is that when the unit holder dies, his or her heirs can inherit the units tax free up to $11.4 million in 2019. Plus the cost basis steps up to the closing price on the date of death. Theoretically, heirs can potentially receive a large income-producing portfolio of MLPs tax free.
#4 Favorable tax rates
If MLP distributions were treated the same as other pass-through stocks (like REITs or BDCs), whose payouts are classified as unqualified dividends, then investors would be taxed at their top marginal tax rates. Following tax reform, these rates look like this for 2019:
Source: Nerd Wallet
Thus MLPs, unlike other kinds of pass-through stocks, benefit from both deferred tax liability and effectively being taxed at the same rate as qualified dividends such as those paid by C corps.
For someone in the top marginal tax bracket, this can translate into a substantial benefit, since distributions would be taxed at just 20% instead of 37%.
#5. 20% pass-through deduction
There’s another benefit that MLPs offer in terms of tax advantage as a result of the 2017 Tax Cuts and Jobs Act.
Specifically, all pass-through stocks, including MLPs, now have a 20% pass-through deduction through the end of 2025 (after which it expires).
In other words, the first 20% of every distribution can be deducted from one’s taxes immediately. This lowers one’s proportional tax burden by 20% and can be claimed by all unit holders regardless of whether they itemize deductions or how much taxable income is reported.
Because the Tax Cuts and Jobs Act about doubled the standard deduction ($12,000 for individuals, $18,000 for heads of household, and $24,000 for joint filers), many more Americans don’t have a need to itemize deductions when filing taxes. Yet, unit holders who do not itemize can still benefit from this 20% pass-through deduction provision.
The Strategic Pipeline Income Fund as an MLP
The Strategic Pipeline Income Fund invests in landowner royalties, in addition to other energy infrastructure areas, in the rapidly growing areas of the Bakken Shale, Permian Basin, and Eagle Ford Shale. The fund has purchase agreements with exclusive pipeline brokers who provide steady royalties from leading suppliers.
If you’re an accredited investor seeking an attractive tax-advantaged dividend yield along with a diversification play for your portfolio, then download our Investment Summary to learn about the fund.