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The Rewards and Risks of Investing in Master Limited Partnerships, by Jeffrey M. Mutnik, CPA/PFS

Posted on August 11, 2022

Master limited partnerships (MLPs) are publicly traded businesses that usually make periodic distributions of their tax-advantaged income to the limited partner owners to avoid corporate taxes. Most often they operate in the traditionally stable energy and natural resource industries, which provide partners with a steady income stream and predictable returns. In fact, as of July 25, 2022, the S&P MLP Index recorded a 15.50 percent one-year return compared with compared with -8.8 percent for the S&P 500. Despite these benefits, MLPs can come with a series of tax reporting, compliance, and liability complexities, which, at times, may amount to more than the gains the investments generate.

How are Investors Taxed on MLPs?

The pass-through structure of an MLP shields it from entity-level corporate taxes while enabling it to distribute a larger percentage of cash flow to investors. While these distributions represent a return on investors’ capital as adjusted, investors may defer any related tax liabilities until the point they sell their interests in the MLP.

However, the MLP’s partnership structure passes onto investors the obligation to report their individual shares of all their MLP’s activities, including income, gains, losses, and credits. These activities could generate tax liabilities or tax benefits in any given year of ownership and affect investors’ tax basis, or the amount they paid for shares in the MLP, plus or minus adjustments. Each distribution decreases the basis of the investment. In turn, the lower basis will have tax implications upon the sale of the interest. Further, as a partnership interest for tax purposes, the partner/investor is subject to all the complicated partnership rules, which can include distributions in excess of basis, depreciation recapture, “hot asset” taxation, “step up” or “step down” at the death of the partner, and others.

Another surprise for many investors is the way in which MLPs report their activities.  Rather than sending out 1099s that report earnings during a tax year, MLPs issue partnership K-1s that detail all of their underlying activities, which investors must report on their personal tax returns. Unitholders who anticipated their investments would yield tax-free cash flow are often startled by the resulting taxes on their share of the MLP’s profits. Operating losses incurred are limited in their usefulness, as they usually are passive losses to the investor and must be suspended until the same activity generates income in a future period or until there is a disposition of the investment.  Moreover, many MLPs operate in multiple taxing jurisdictions.  Therefore, investors may meet filing thresholds in some or dozens of states, requiring the filing of individual nonresident income tax returns in those states.  As a result, the compliance costs an investor may incur could alone mitigate any income earned from the MLP.

How Can I Limit My Risk?

Portfolio diversification is the most basic tenet of managing investment risk.  Many investors and/or their investment managers desire exposure to a particular sector of the economy that MLPs can provide.  However, using these vehicles may create unintended tax consequences.  Therefore, the first step in managing risks associated with MLPs is to determine if these types of investments are appropriate for a portfolio.  Do the potential gains outweigh the federal and state tax compliance costs?

Should an investor be undeterred by MLP risk and opt to hold onto the investment in search of high yield and enhanced returns, he or she should meet with an experienced accountant to assess and offer solutions for managing the multitude of tax liabilities and compliance issues that MLP’s demand.  If the combination of risk and cost are too great, the best suggestion is to meet with an investment advisor to identify alternatives for generating similar yield without taking on similar risk.

About the Author: Jeffrey M. Mutnik, CPA/PFS, is a director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he provides tax- and estate-planning counsel to high-net-worth families, closely held businesses and professional services firms. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at info@bpbcpa.com.