MLPs remain a highly tax-efficient way to own midstream energy infrastructure assets, with ETFs offering an easy, affordable way for investors to gain exposure to the industry.
When considering adding MLP investment products to a portfolio, it’s important to keep in mind their tax implications and how they differ from individual MLPs. MLP ETFs generally issue a single form 1099 as opposed to a Schedule K-1. Instead, K-1 forms are processed by the product issuer, and investors are distributed a 1099 form, according to Alerian.
“Comparing the taxation of an MLP investment against the taxation of a C-Corp investment, MLPs possess a tax advantage of 7.2% over C-Corps,” Alerian wrote in an insight. “MLPs clearly benefit from not having to pay income tax at the partnership level, while MLP investors also benefit from the qualified business income deduction.”
MLPs do not pay taxes at the entity level if 90% or more of their income is from qualifying sources#, which are defined in the Internal Revenue Code to include exploration and production, transportation, and other activities involving any mineral or natural resource, according to Alerian.
MLP dividends are called distributions because of the partnership structure. The historical average yield of MLPs over the past 10 years has been around 7%, which means that if an investor invested $100, on average, they would be paid $7 each year, according to Alerian.
Typically, 70%–100% of MLP distributions are considered tax-deferred return of capital, with the remaining portion taxed at ordinary income rates in the current year.
As long as the investor’s adjusted basis remains above zero, taxes on the return of capital portion of the distribution are deferred until the units are sold.
If an investor’s basis reaches zero, then future cash distributions will be taxed as capital gains in the current year. At the time units are sold, the gain that results from basis reductions is taxed as ordinary income with a 20% deduction, while the remaining amount is taxed as a capital gain, according to Alerian.
The passage of the Tax Cuts and Jobs Act in 2017 allows taxpayers to receive a deduction of 20% on qualified business income from MLPs.
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