MLPs do not pay dividends. Instead, they make cash distributions governed by their partnership agreements, which typically mandate the distribution of all available cash flow. Because midstream infrastructure assets incur massive depreciation and amortization expenses, the taxable ordinary income allocated to partners is significantly lower than the physical cash distributed.
The tax characterization of these distributions is split into two components:
The portion of the cash distribution that represents your share of the partnership’s net taxable income. This is taxed immediately at your marginal ordinary income rate.
The portion of the cash distribution that exceeds the partnership’s taxable income. This component is completely tax-deferred. Instead of being taxed in the year received, ROC distributions reduce your cost basis in the MLP units. Taxes are deferred until you sell the position.
Historically, 80% to 90% of an MLP’s annual cash distribution is shielded as return of capital, making them highly cash-efficient for high-bracket investors. However, if your continuous basis reductions grind your cost basis down to zero, all subsequent distributions are taxed immediately as capital gains.