A master limited partnership (MLP) is a unique investment that combines the benefits of a pass-through tax treatment with the liquidity of a publicly traded common stock.
Although an MLP has a partnership structure for tax purposes, it issues shares or units that trade on an exchange like common stock of a corporation.
The U.S. federal income tax treatment of MLPs is governed by the Internal Revenue Code of 1986, as amended, which specifies eligible sources of income and other requirements that an MLP must satisfy to qualify for the tax benefit of a pass-through tax treatment and avoid income tax being imposed on the MLP itself. To obtain this favorable tax treatment, an MLP must earn 90% of its gross income from “qualifying” sources, including certain activities relating to natural resources, commodities or real estate.
The tax treatment of MLPs differs significantly from that of entities treated as corporations for tax purposes, for both the entity and its investors. As noted on the previous page, for an MLP there is no federal income tax at the entity level. This lowers an MLP’s cost of capital compared with an entity taxed as a corporation, since there is no double taxation on an MLP’s income and distributions to investors, as is the case with corporate income and its dividends. Companies that are eligible to be treated as MLPs therefore have a strong incentive to do so because pass-through tax treatment provides a cost advantage over their incorporated peers.
Instead of paying a corporate income tax, the U.S. federal income tax liability, with respect to the MLP’s income, is imposed on the MLP’s investors. Once a year, each investor receives a Schedule K-1 (form 1099-DIV in the case of corporations) detailing his or her share of the MLP’s income and deductions, which is then taxed at the investor’s particular tax rate.
One important distinction must be drawn here: Although the MLP’s income is passed through to its investors for tax purposes, the actual cash distributions made to investors frequently do not correspond to the MLP’s income for tax purposes. Instead, cash distributions are based on the MLP’s distributable cash flow (DCF), similar to free cash flow (FCF). Unlike dividends, these distributions are generally not taxed when they are received. Instead, they reduce the investment’s (tax) “cost basis” and create a potential tax liability that arises generally when the investor sells its interest in the MLP.
MLPs generally have much higher distributable cash flow than they have taxable income. This is a result of significant depreciation and other tax deductions, and is especially true of natural gas and oil pipeline and storage companies, which are some of the most common businesses operated using an MLP structure.
In such cases, investors may well receive cash payments that exceed the amount upon which they are taxed, which can defer tax. The taxable income passed on to investors is often only 10% to 20% of the cash distribution, while the other 80% to 90% is deemed a return of capital and subtracted from the original cost basis of the initial investment.
Let us look at an example of the mechanics of cash flows and taxes that occur when holding and selling MLP interests. Let us assume an investor purchases an MLP interest for $25 per unit, holds it for three years, receives cash distributions of $1.50/unit per year and is allocated $0.30/unit of net income per year, consisting of $1.50 in gross income and $1.20 in depreciation deductions.
First, calculate the change in cost basis caused by the amounts treated as returns of capital—cash distributions minus allocation of taxable income for each year—over the life of the investment. For simplicity, assume that taxable income and cash distribution remains constant through the life of the investment, although in reality these probably would fluctuate each year.
If the MLP is sold at the end of the third year for $26 per unit, the investor will gain $4.60. One dollar of this will generally be treated as capital gain—i.e., the profit from the sale above the investor’s cost basis, ignoring basis reductions that arise from depreciation deductions— which would be taxed at the long-term capital gains tax rate. The remaining $3.60 gain reflects the “recapture” of the depreciation deductions allocated to the investor, and will be taxed as ordinary income at the investor’s income tax rate. The next table shows cash flows, including those related to taxes, during the life of the investment. We assume a 35% ordinary income tax rate and a 15% long-term capital gain rate.
An important side note on the concept of reducing cost basis: If and when the investment’s cost basis falls to zero, any cash distribution becomes immediately taxable, rather then being deferred until the sale of the security. This is because the investment cannot fall into a negative cost basis. Cost basis can fall to zero, if an MLP is held for many years.
Because the tax deductions for depletion and other items accorded to MLPs often exceed the MLP’s actual expenses MLPs can be used to gain current economic income while deferring taxes, as seen in the previous example. MLP investments can also be used as a vehicle for estate planning.
MLPs typically have two classes of partners: the limited partner (LP) and the general partner (GP). The limited partner invests capital into the venture and obtains periodic cash distributions, while the general partner oversees the MLP’s operations and receives incentive distributions rights (IDRs). IDRs are typically created and structured when the partnership is formed, and provide the GP with performance- based pay for successfully managing the MLP, as measured by cash distributions to the limited partner.
Generally, the GP receives a minimum of 2% of the total distribution, but as total payments to LP unitholders increase, the percentage take of the GP through IDRs increases too, often to a maximum of 50%. The the following table shows a hypothetical IDR structure outlining the payment split between LP and GP at different distribution levels.
For each incremental dollar distributed to LP unitholders, the GP realizes higher marginal IDR payments. For example, assuming 1,000 LP units outstanding, if $1,000 is distributed to LP unitholders ($1.00 per unit), then the GP will receive $.0204/unit, rounded down to $0.02. However, if $5,000 is distributed to LP unitholders ($5.00 per unit), then the GP will receive $2,810, as outlined below.
In this hypothetical scenario the GP’s entitlement is calculated as a percentage of the total distributions: thus the calculation of the GP’s payment for each tier is not a straight multiplication of the GP’s IDR by the LP’s distribution. The calculation goes as follows:
Thus, at the third tier, the GP payment would be
Here we see that the general partner has a significant financial incentive to increase cash distributions to limited partner unitholders; while LP distribution increases 500%, from $1,000 to $5,000, GP distribution increases by more than 14,000%, rising from $20 to $2,810. Note in the calculations in the above table that the IDR payment is not a percentage of the incremental LP distribution amount, but rather a percentage of the total amount distributed at the marginal level. For example, in the third tier, $1.54 is distributed per LP unit; $1.00 (65%) of that amount paid to LP unitholders, $0.54 (35%) paid to the GP.
The capital structure of MLPs can be more complex than a simple
split between the limited and general partnership interests. In some cases, the GP may own LP shares. In other cases, the GP of an MLP may be publicly traded and have its own LP/GP split. Or the MLP may have other relationships with additional entities due to financing arrangements. But an important relationship for the MLP investor to keep in mind is the cash distribution split between LP and GP, and how this will change over time as distributions fluctuate.
MLPs have remained relatively unknown in part because of their low level of institutional ownership and a consequent lack of attention from sell-side analysts. Mutual funds were largely restricted from owning them until 2004. Even now, MLPs present a cumbersome investment because funds must send out 1099 forms to their investors detailing income and capital gains in November, but may not receive K-1 statements from MLPs until February. This creates potential for costly mistakes in estimation.
Tax-exempt institutional investment funds such as pensions, endowments and 401(k) plans are deterred from owning MLPs because certain income derived from an MLP is considered unrelated business taxable income (UBTI) that is taxable to the entity if income exceeds $1000. This tax also applies to an individual retirement arrangement (“IRA”) account in which an individual might hold an MLP; therefore, individuals may wish to consider holding MLPs in a regular brokerage account. When held directly, MLP investments are also challenging from a state tax and related reporting perspective.
Individual investors are among the most common owners of MLPs. Because individuals may not know much about their structure and complex tax implications, they are often purchased for individuals by private-client wealth managers, although this need not be the case. Those considering investing in MLPs should consult with their financial and tax advisors to understand the tax consequences and considerations associated with investing in MLPs in light of their particular tax situations, including how to manage the K-1 statement and cash distributions.
The discussion above assumes that an MLP qualifies for pass-through tax treatment. This discussion also assumes that each investor in an MLP is a U.S. person for U.S. federal income tax purposes. Investors who are not U.S. persons are subject to special tax rules that are not described herein, and should consult their tax advisors in light of their particular tax situations.
Investing involves risk, including possible loss of principal.
AMG Distributors, Inc., is a member of FINRA/SIPC.
You are now leaving the AMG Funds web site: The link you have selected is located on another web site. Please click OK below to leave the AMG Funds site and proceed to the selected site. AMG Funds does not endorse this web site, its sponsor, or any of the policies, activities, products or services offered on the site, or by any advertiser on the site. AMG Funds has no control of the content or data shown on this site, and while AMG Funds has no reason to doubt the reliability of the data shown, its accuracy is not guaranteed. Furthermore, AMG Funds takes no responsibility for the accuracy or factual correctness of any information posted to third party web sites.
Thank you for your interest in AMG Funds.OK