Over the past few years, Master Limited Partnerships (“MLPs”) have gained a lot of attention. Investors have been drawn to the dividend yield offered by many of these entities. Certain companies, like The Blackstone Group, L.P., have been able to structure their operations to qualify for partnership tax treatment in a public offering. In addition, investment advisors have set up a host of products, such as Exchange Traded Notes, ETFs, Open and Closed End Funds, to allow investors access to this investment class.
Overview of MLPs
Master Limited Partnerships (often referred to as Publicly-Traded Partnerships or PTPs) are publicly-traded limited partnerships that meet the passive income requirements under the Tax Code, allowing them to be taxed as a partnership. Unlike corporations, MLPs are not subject to entity-level federal taxation. Instead, MLPs allow for the flow-through of taxable income to investors.
A MLP meets the passive income test if 90% or more of the MLP’s gross income during the tax year is derived from “qualifying income.” Specifically, qualifying income for this test consists of the following:
Real property rents
Gain from the sale or other disposition of real property
Income and gains derived from the exploration, development, mining or production, processing, refining,
transportation, or marketing of any mineral or natural resource
Any gain from the sale or disposition of a capital asset held for the production of income
Income and gains from commodities, futures, forwards and options with respect to commodities
Many MLPs operate in energy infrastructures, which transport petroleum, natural gas, and propane and engage in the storage, processing, exploration and production of natural resources. Therefore, they meet the qualifying income test and can be treated as partnerships for income tax purposes. Certain investment advisory businesses, ETFs and other businesses also may meet the requirements to be taxed as a partnership. Visit www.naptp.org for a list of currently-traded MLPs.
Investors in a MLP receive Schedule K-1s each year, which report their allocation of the MLP’s income, expenses, and gains and losses for the tax year. This differs from an investment in a corporation, where the investor receives a 1099-DIV to report the amount of dividends he or she received. The K-1 also provides information regarding the MLP’s activities in various states, which may or may not create state filing requirements for investors. Investors take the information reported to them via the K-1 and recognize those items on their individual tax returns (both federal and state) and pay the corresponding tax. Any cash distributions paid by the MLP during the year generally are considered return of capital to the investor and typically are not subject to current tax. This flow-through treatment eliminates the “double taxation” seen with traditional corporate investments, where the corporation pays tax on their current taxable income and then investors pay tax on any current year distributions received from the corporation’s earnings and profits.
Fund Investments in MLPs
A Registered Investment Company (“RIC”) under Subchapter M of the IRC is afforded the tax efficiency of a flow-through investment by means of a dividends-paid deduction. As long as the RIC meets the qualifications under the Tax Code, the RIC is able to take a deduction for dividends paid to its investors and effectively reduce its taxable income to zero. One of the requirements is that a RIC not invest more than 25% of its total assets in securities of Qualifying Publicly-Traded Partnerships (QPTP). A MLP generally would meet the definition of a QPTP. Consequently, if a RIC invests more than 25% of its assets in the securities of one or more MLP, the RIC will not meet the qualifications under Subchapter M and generally would be subject to an entity-level tax.
Several funds have been launched with a core strategy of investing in MLPs, despite the adverse tax consequences of failing to meet the RIC requirements. An investment company that invests more than 25% of its assets in QPTPs still may register with the SEC as an investment company under the Investment Company Act of 1940. However, the investment company’s failure to meet the RIC tax qualification requirements would cause the fund to be taxed as a corporation and be subject to an entity-level tax. This would create current and deferred tax assets or liabilities of the fund, which must be included in the fund’s calculations of its Net Asset Value (“NAV”). These computations are complicated and include the use of estimates of the fund’s federal and state income tax rates. The fund would be required to file a Federal Form 1120 and other relevant state tax returns in order to calculate, report and pay its relevant tax liabilities.
Distributions from MLP Funds that are taxed as corporations are taxed like other corporate distributions—as dividends to the extent of the corporation’s current or accumulated earnings and profits. To the extent distributions are in excess of the corporation’s current or accumulated earnings and profits, they are treated as return of capital distributions to the extent of an investor’s basis in the corporation. Any excess distributions are treated as capital gains to the investors.
The discussion in this article only scratches the surface of the complex tax compliance issues associated with investing in MLPs. Cohen Fund Audit Services, Ltd. is in a unique position to assist with the tax compliance and financial statement requirements for RICs interested in investing in MLPs and for fund sponsors interested in organizing a fund with primarily MLP investments.
To discuss MLPs, contact one of our professionals at 216.649.1700 or email us at firstname.lastname@example.org.
The information is provided by Cohen Fund Audit Services and is intended for informational purposes only. Consult with legal and other advisors before taking any specific action. Notwithstanding that these materials do not constitute legal, accounting or other professional advice, as may be required by United States Treasury Regulations and IRS Circular 230, you should be advised that these materials are not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax laws. No written statement contained in these materials may be used by any person to support the promotion or marketing of or to recommend any federal tax transaction(s) or matter(s) addressed in these materials, and any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor with respect to any such federal tax transaction matter.