Addressing Common Investor MLP Questions

Master Limited Partnerships (MLPs) are admittedly a niche investment opportunity. As such, investors are often unfamiliar with MLPs and their tax advantages. This note addresses commonly asked MLP questions from taxation to different ways to get MLP exposure without receiving a Schedule K-1.

What are MLPs?

A Master Limited Partnership is a publicly traded limited partnership with an advantageous tax structure. MLPs trade on major exchanges, and their shares are called units. Owners of MLPs are often called unitholders or partners.

MLPs must receive at least 90% of their gross income from qualifying sources. Since the late 1980s, this has generally included the transportation, processing, storage and production of minerals and natural resources. The recently passed One Big Beautiful Bill Act (OBBBA) expanded the sources of qualifying income for MLPs (read more).

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Do MLPs really not pay taxes?

MLPs are pass-through entities and do not pay federal taxes at the company level. Investors that directly own individual MLPs will receive a Schedule K-1 each year for filing their taxes. The K-1 details the unitholder’s proportional share of income, deductions, losses, and credits. Ultimately, the unitholder pays taxes at their personal rate on the net income ascribed to them, with a 20% deduction for qualified business income (QBI). The OBBBA made the 20% QBI deduction permanent.

A unitholder with a large position may need to file state income taxes for the income allocated to them in the states where the Master Limited Partnership operates. However, minimum income thresholds likely limit this.

Investors have historically been attracted to MLPs due to their generous income. The Alerian MLP Infrastructure Index (AMZI) was yielding 7.4% as of July 25. Importantly, MLP income is not only generous but comes with special tax advantages.

What is an MLP distribution? How does it compare to a C-Corp dividend?

The payouts or dividends from MLPs are called distributions. MLP distributions are considered a return of capital and are not taxed when received. Instead, distributions lower an investor’s basis in the units and are ultimately taxed when the MLP units are sold (see more below).

Historically, MLP distributions have been noticeably greater than the taxable income assigned to the unitholder. An MLP distribution may be described as 80% or 90% return of capital. In that case, the taxable income for the year is being compared with the distribution to estimate the overall tax deferral.

Dividends from corporations are subject to double taxation, with the corporation paying taxes on its profits and the investor paying taxes on the dividends received. Corporate dividends are often qualified dividends and taxed at capital gains rates if holding period requirements are met. Unlike corporate dividends, MLP distributions are not subject to double taxation and offer the potential for tax deferral (read more).

Why does basis matter for MLP investing?

Investors are typically familiar with cost basis, which is the price paid for a stock. Basis is particularly important for MLP investments, because the basis changes over time. Specifically, distributions lower an investor’s basis in an MLP, and the income assigned to the unitholder raises the basis. Deductions like depreciation also lower basis.

As long as a unitholder has a basis above $0, the tax on distributions is deferred until units are sold. If the basis falls to $0, distributions are taxed at capital gains rates. If a unitholder passes away, the basis for heirs is set to fair market value at the date of death. In that case, the past distributions received by the deceased are never taxed (assuming the basis was above $0). For this reason, MLPs can be an interesting estate planning tool.

When a unitholder sells an MLP, not all gains are taxed at capital gains rates. For example, basis reductions from depreciation are taxed at ordinary income rates (with the 20% QBI deduction). This is referred to as basis recapture (read more).

Can I own MLPs in my retirement account?

Investors can directly own individual MLPs in a retirement account, but it tends to be suboptimal for two reasons. First, MLPs can generate Unrelated Business Taxable Income (UBTI) for retirement accounts (and tax-exempt organizations). Practically all the taxable income from an MLP is considered UBTI, and an investor could incur taxes if UBTI exceeds the $1,000 allowed deduction (read more). Note that MLP-focused investment products like ETFs, exchange traded notes (ETNs) and mutual funds do not generate UBTI.

Another reason to avoid owning individual MLPs in retirement accounts is that they are already tax-advantaged investments. Arguably, there is more benefit to owning fully taxable investments in a tax-advantaged account.

How can I get MLP exposure without receiving a Schedule K-1?

If an investor directly owns an individual MLP, they will receive a Schedule K-1 for filing their taxes. However, investors can access the MLP space through ETFs, ETNs, mutual funds, and other vehicles to receive a Form 1099 and avoid a K-1 (read more).

Investors should familiarize themselves with the tax implications of these different products. For example, an MLP ETF can replicate some of the tax advantages of a direct MLP investment with the potential to provide tax-deferred income. Meanwhile, the coupons from ETNs are taxed at ordinary income rates, making them more suitable for tax-advantaged accounts.

Of note, there are two types of MLP ETFs or mutual funds due to tax treatment. There are funds that limit their MLP exposure to 25%, which are more total-return-oriented, and funds that predominantly own MLPs, which are more income-oriented (read more).

For more information on MLPs and MLP investing, please view our MLP primer or see the related research below. Please also join our next 30-minute webcast on August 12 at 12:30 p.m. ET, where the MLP/midstream investment case will be discussed (register here).

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AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB).

MLP 101: Addressing Common Investor Questions