How to Avoid Taxes on 80% of Your Investment Income. Hard to believe, right? But thanks to the way the US government supports US oil and gas companies, you may only pay taxes on around 20% of your income from energy related Master Limited Partnerships (“MLPs”). As an investor, this can be a pretty good deal.

Master Limited Partnerships are required to pay out 90% of their profits to shareholders much like Real Estate Investment Trusts. Unlike REITS, the payments an MLP makes to a shareholder are considered to a “return of capital” until the full principal is paid off at which point it converts to a taxable distribution, but with potentially significant offsets to those taxes as a result of being a partnership. Energy MLP’s pay anywhere from a 4% to an 8% distribution, sometimes more.

Here’s how it works.
The hydrocarbon industry can be generally divided into three major classes: upstream operations, mid-stream operations, and downstream operations.
Upstream: These are the companies that work the fields – they build and maintain wells and draw oil and natural gas out of the ground.
Midstream: These companies control the pipelines or other transport systems to get the product from the upstream players to the downstream players.
Downstream: These are the companies that process and refine the hydrocarbons and also get them to the end users be it a major plastics manufacturer or a the gas station down the road.

In each of these classes companies have choices in how they organize themselves. Many choose a “Master Limited Partnership” partner structure and that is where the incredibly favorable tax treatment kicks in.

What are you actually taxed on when an MLP pays a distribution or partner’s share of net income? The difference between the distributions from your shares minus depreciation and maintenance expense.

Let’s look at a basic illustration of the concept. Let’s say you put $100,000 into an MLP stock, with a distribution rate of 10%. At the end of the year, you will have received $10,000 in distributions. Let’s say your shares are eligible for $7,000 of the company’s depreciation for the year, and another $2,000 in maintenance costs. From the IRS viewpoint, you earned $1,000 and that’s what you will get taxed on.

Not quite tax free, but pretty darn close considering. You picked up $10,000 you can spend on whatever, but only get taxed on $1,000 of it.
Wow, sounds great, right? But as in everything they do they government giveth and the government taketh away.

The IRS gets a big chunk of it’s money back when you sell your MLP shares. They view the depreciation and maintenance expenses as reducing your cost basis upon sale, and you can’t take depreciation against the income once your cost basis hits zero. You now get taxed at your income tax rate, not the capital gains rate.

You have to file a K-1 to file with the IRS. Here is where the pain starts. For those that don’t know, that’s a partnership tax form. They can be complex and if you aren’t a tax whiz, you are going to need to get your CPA to handle it. That may cost you a fair chunk of change each tax year. It’s also possible you will have to file in multiple states as a result, further complicating the picture.

If you hold on to your MLP shares for a decade or two, your cost basis is going to be at or pretty close to zero. If you sell, the IRS is going to want the difference between what you sold it for and what you paid for it, plus the depreciation and maintenance deduction.
There is a solution, which I will get to in a bit.

What about other drawbacks? MLP’s, like other oil and gas businesses, make more money when prices are higher and less when prices are lower. The issue? MLP’s usually borrow heavily to build their infrastructure. If prices fall too far, they may have trouble meeting their debt obligations, potentially a bad situation for shareholders if the company goes bankrupt and has to be reorganized – bond holders usually get first claim on the assets.

Is this a real risk? Maybe yes and maybe no – if you own individual MLP’s your risk is higher. If you own a basket of MLP’s, odds are pretty good most of them will make it through the low price period.

The other difficulty with MLP’s is that they are really designed for taxable accounts and some of their appeal is lost if they are owned inside tax deferred accounts such as IRA’s. That can trigger what’s known as the UBTI or “unrelated business taxable income.” That’s when the IRS basically says you owe that money and owe it right now even though you own the MLP inside an IRA. That can create other problems depending on your age and whether or not you have funds you have to withdraw from the IRA to pay Uncle Sam. And you still have those damn partnership forms.

There are other risks that are more difficult to estimate;

Will regulations change? In other words, will the government continue to allow this tax structure for MLP’s? Probably, but maybe not.

MLP’s seem likely to see some kind of adjustment when interest rates finally start rising. This could cause the price of MLP shares to drop.

It can be tough to understand the debt structure of an MLP and what point falling oil or gas prices will force them into bankruptcy or reorganization?

How do the very wealthy (or the very shrewd) handle MLPs? When they buy an MLP they basically plan to never sell. By never I mean ’till death do us part. The shares of the MLP get passed on to the next generation, but the accumulated depreciation accompanies you to the hereafter, leaving the shares unencumbered by a big depreciation recapture. On top of that, the cost basis gets reset to whatever the market price is at the time of inheritance using what is called a “step up.” So, your kids can now take that income and depreciate against it the same way you did, or they can sell the shares without capital gains taxes.

So, for some people MLPs can be a stellar investment. For others, MLPs may represent tax complications that make you want to strangle your CPA and investment advisor.

For the right investor, MLP’s can be a powerful option. Just don’t make the mistake of putting all your eggs in one basket, or in this case all your money into MLPs. It could work out well, but it could also turn out to be a spectacularly poor decision. Consult your advisor and your CPA and do some homework to make sure this type of investment fits within your risk tolerance.

Want more detail? Good article by the Executive Director of the MLP Association just click the title –> Making Sense of Master Limited Partnership Tax Rules.

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To Smarter Investing,

Dak Hartsock
Chief Market Strategist
ACI Wealth Advisors, LLC.