Master limited partnerships, or MLPs, have been around since the early 1980’s. They offer investors a way to invest in America’s energy infrastructure and pay a nice dividend to boot. Yet because of tax complexities associated with MLPs, some investors avoid them altogether.

A common complaint is that the tax treatment of MLP dividends—technically, cash distributions—are complicated.

Avoiding Double Taxation

First, MLPs offer a tax advantage in that they are not taxed at the entity level. Taxes flow through to the individual unitholder. (Each share of an MLP is a partnership unit.)

A regular corporation is taxed at the corporate level, and then the shareholder pays tax on the dividend. This is known as double taxation.

Let’s say a corporation pays a 21% tax on profit, and then pays out a dividend. The shareholder has to pay a 15% rate on the qualified dividend received. The end result is that in total he/she is effectively taxed at roughly a 33% rate!

In the case of MLP cash distribution, the taxable portion is taxed at the marginal tax rate. Still, even if your marginal tax rate is 28%, when considering double taxation, you end up paying a smaller-percentage tax.

Note that I said “the taxable portion.” Does this mean you don’t owe taxes on some of an MLP’s cash distribution?

Yes and no.

Tax Deferment

While the terms “dividend” and “cash distribution” are sometimes used interchangeably, and they both result in an investor receiving cash from the company they invested in, they aren’t the same thing.

A cash distribution consists of both return of capital and income. Typically, most or all of the distribution is considered to be return of capital. This part is tax deferred. This means you usually only have to pay taxes on a small portion of the distribution, the part considered income.

The amount that’s considered return of capital lowers your cost basis. And when you sell the units, that’s when you will pay the deferred tax in the form of capital gains.

For example, if your original cost basis was $50 per share, and you received $10 in total return of capital over time, your cost basis would be lowered to $40. So lowering your cost basis will increase your capital gains in the future. However, note that some of your gain when you sell can be considered ordinary income. You will need to consult Form K-1 that the MLP will send you.

UBTI in Tax-Sheltered Accounts

Another characteristic of MLP investing that gives investors pause is the potential UBTI (unrelated business taxable income).

This comes into play only for tax-sheltered accounts like IRAs. The IRS allows tax deferment for an IRA when that IRA generates income from activities related to saving for retirement, such as investing in stocks. However, when you buy MLP units in an IRA, that IRA technically becomes an owner in the MLP, whose core business is typically transporting and processing oil and gas. Since such business doesn’t have to do with retirement savings, the IRS considers income from the MLP UBTI.

Note that the UBTI is not only limited to the income part of cash distributions. As mentioned earlier, parts of capital gains can be considered to be “ordinary income” and count toward the UBTI tally as well. If you invest in MLPs, consult the Form K-1 that MLP sends you to determine how much UBTI you incurred that year.

If the total UBTI in an IRA is more than $1,000, then the amount over $1,000 is taxable. The end result is that you could end up paying taxes from an account that’s supposed to shelter you from taxes until you withdraw money from it.

No Extra Benefit When Held in IRA

To be clear, the reason you may hear that MLPs should not be held in IRAs is that there’s no additional tax benefit to holding MLPs in an IRA. It’s not because holding an MLP in an IRA triggers any taxable events that otherwise would not have occurred. In other words, the income that’s counted as UBTI in an IRA would be considered taxable income anyway if the MLP was held in a regular brokerage account.

A licensed tax professional should be able to take care of the complexities for you without a ton of headache, but ultimately, only you can decide whether owning an MLP is worth the extra tax complexities.

There are also some ways to get around the issues. Spreading MLPs across multiple IRAs reduces the amount of UBTI in any one account, and could keep UBTI under the $1,000 threshold. Buying an MLP ETF, instead of individual MLPs, can also insulate you from the aforementioned issues as well because you own shares of an ETF, not the MLP itself, so there’s no UBTI.

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