Master Limited Partnerships (MLPs) are flow-through tax entities, meaning the obligation to pay taxes flows through to the partners. As a limited partner (or “unitholder”) in an MLP, you are responsible for paying your share of the partnership’s tax obligation. You are allocated a share of the MLP’s income, gains, losses, and deductions based on your percentage ownership in the MLP. You report these figures on your tax return and pay any taxes due. This structure eliminates the “double taxation” generally applied to corporations, where the corporation pays taxes on its income, and shareholders also pay taxes on dividends.
Record keeping When investing in MLPs, it is crucial to keep detailed records from the beginning. You need to track the tax basis of your MLP investment from purchase to sale. Your initial tax basis reflects the value of your initial investment and serves as the starting point for calculating future gains and losses.
Unlike simpler investments, MLPs require ongoing adjustments to your tax basis. Your tax basis decreases by the amount of cash distributions you receive from the MLP and increases by your share of the MLP’s taxable income (or decreases by your share of taxable losses).
Distributions vs. Dividends MLP cash payments to unitholders are referred to as “distributions”, not dividends. MLPs are generally required to distribute most of their distributable cash flow to unitholders, typically on a quarterly basis. These distributions are based on the MLP’s cash flow, which is often larger than its taxable income due to non-cash deductions like depreciation.
Depreciation and Tax Deferral Your share of the MLP’s depreciation expense is included in your share of taxable income. The amount of depreciation allocated to you depends on various factors, including your purchase price and additional depreciation from new investments by the MLP. This depreciation can defer your overall tax bill.
Many MLPs have little or no taxable income, making cash distributions in excess of taxable income tax-deferred. These tax-deferred distributions are considered a “return of capital” and reduce your tax basis in the MLP.
The tax deferral mechanics can be complex. While it is often assumed that 80% of an MLP’s distributions are tax-deferred, this is an oversimplification. The actual amount of tax deferral varies based on the specific circumstances of each MLP and the timing and price of your investment.
IRS Pub. 541, “Partnerships” and IRS Pub. 925, “Passive Activity and At-Risk Rules” provides details of taxation.
When you sell a Master Limited Partnership (MLP), you calculate your gain or loss similarly to other investments. Your taxable gain is the difference between the sales price and your adjusted tax basis. However, this gain is not uniformly taxed; it is divided into two components.
The portion of your gain attributable to depreciation is taxed at ordinary income rates, known as “recapture”. This information is provided in a supplemental sales schedule of the K-1 package. Essentially, instead of paying ordinary income tax rates when you received your cash distribution, you deferred some tax due to the depreciation deductions passed through by the MLP. Upon sale, the government “recaptures” this deferred tax, and you pay it at ordinary income rates.
The remainder of the gain, calculated as the difference between your sales price and tax basis minus the ordinary gain reflected on the K-1 sales schedule, is taxed at the applicable capital gains tax rate, depending on the holding period.
Example calculation: Suppose you purchase 100 units of MLP at $10 per unit, totaling $1,000. After one year, you sell these 100 units for $12 per unit, receiving total sales proceeds of $1,200. With a tax basis of $952, your gain is $248. Of this gain, $28 is taxed as “recapture” at ordinary income rates due to the depreciation deduction previously received, while the remaining $220 is taxed as capital gains.
Upon receiving your tax documents (Schedule K-1) after one year, you note $60 in cash distributions and $12 in taxable income. You calculate your adjusted tax basis at year-end as follows:
The $12 in taxable income is reported on your K-1. The $40 and $(28) are not provided by the MLP on a K-1 but are included here to illustrate how the MLP calculates taxable income/(loss).
UBTI and the IRA wrapper. Hold MLP units in a taxable account, not in a traditional IRA, a Roth IRA, or any other tax-deferred wrapper. The depreciation-driven deferral that makes the MLP attractive only works on the outside; inside an IRA, that deferral is structurally meaningless and the pass-through income is recharacterized as UBTI — unrelated business taxable income — under IRC §511, “Imposition of tax on unrelated business income of charitable, etc., organizations”, which the IRA itself owes above $1,000 per year at the trust ordinary-income rate (reaching 37% near $16,000 of taxable income). The custodian files Form 990-T on behalf of the IRA and the tax is paid from the IRA’s assets. The same rule applies to leveraged real estate held in a self-directed IRA, where the unrelated-debt-financed-income rules under IRC §514, “Unrelated debt-financed income” convert a portion of otherwise-passive rental income into UBTI: hold the leveraged property outside the IRA. The only structure that justifies MLP exposure inside an IRA is an open-end MLP ETF or a C-corp-structured product, which blocks UBTI at the entity level at the cost of an internal corporate-tax drag — and even then, the same exposure in a taxable account is cleaner and cheaper.