In my work as a financial writer, the most frequently asked questions from readers concern master limited partnerships (MLPs). More specifically, the questions are usually about the tax implications that comes with owning these partnership units. The two factors that give MLP investors the biggest headaches are the K-1 and the UBTI (unrelated business taxable income). Let’s make them less daunting.

Schedule K-1

The K-1 is a tax document. Its official name is Schedule K-1 (aka Form 1065). The MLP will prepare and mail it to every unitholder of record. This is the form for partners to report to Uncle Sam the income, loss, and distributions received. MLP unitholders get this form because they are considered to be partners in the MLP.

If you invest in MLPs, make sure you keep a copy of every K-1 you receive. You will need the records to keep track of your cost basis and the various distributions you receive over time.

Unlike a C corporation, an MLP isn’t taxed at the entity level. This makes MLPs tax-advantaged because unitholders aren’t taxed twice. By contrast, a corporation’s profits are taxed, and then the dividend paid to shareholders are taxed again at the individual level.

However, the end result of avoiding entity-level taxation is that the MLP’s tax-related aspects such as income and loss, deductions and credits, are divided among the partners, i.e. the unitholder holders. This means if the MLP had taxable income, you will owe taxes on your share of it. In other words, the MLP’s income or loss is passed down to unitholders.

Distributions Will Cover the Income Tax

Don’t freak out though, the MLP’s cash distribution will usually cover any income tax from the MLP. This is because non-cash expenses such as, primarily, depreciation will greatly reduce taxable income. When you pay tax on your MLP cash distribution, you are actually paying income tax, not dividend tax. And if the distribution is higher than your share of the MLP taxable income (it usually is), the portion above the taxable income is considered to be a return of capital and is not taxed.

However, this doesn’t mean that you won’t have to pay taxes on the amount exceeding the taxable income. Rather, the tax is deferred. You have to reduce your cost basis by the return of capital so that when you sell your units in the future, you will have to pay taxes against a lower cost basis. On the other hand, the taxable income you receive adjusts the cost basis upward. And when you do sell, the portion of your gain that’s attributable to reduction in cost basis due to depreciation deductions will be taxed at the ordinary income rate, while the balance is taxed at the capital gains rate.

For example, let’s say you buy $1,000 worth of an MLP and you hold it for three years and sell the position for $1,300. Over the three years, your cost basis was lowered by $200 due to the depreciation reduction on the distributions received but it was increased by $100 due to your portion of the taxable income. Thus, on the day you sell, your cost basis would be $900. Of the $400 gain, $200 would be taxed as ordinary income, and the rest will be taxed as capital gains.

Yes, it does sound quite complicated, but the MLP will calculate and break down the numbers for you so that you just have to make sure you enter the correct numbers in the correct lines on your tax return. You should, however, still keep track of the K-1s yourself to check for possible errors.

UBTI

The second issue only pertains to MLPs held in tax-sheltered accounts, such as Individual Retirement Accounts (IRAs). When held in an IRA, a certain part of the income received is considered to be UBTI. Remember though, most of the cash distribution you receive from an MLP is actually return of capital. It will be a portion of the taxable income that will count toward UBTI. The first $1,000 of UBTI in each account per year is exempt. For most investors, their UBTI never come close to the threshold. And if you have multiple IRAs, you can spread your MLPs among the accounts. Again, it’s important to check your K-1.

When you sell an MLP in an IRA, though, it could also trigger UBTI tax. For most investors, this is the more likely scenario than UBTI tax on distributions. When an MLP is sold, the portion of the gain considered to be ordinary income is considered UBTI. So if the ordinary income part in your gain is higher than $1,000, the amount above $1,000 is taxable.

Only you can decide if the MLP’s attractive yields are worth the extra wrinkles. In my experience with MLPs, they aren’t that bad, but it does require extra work come tax time. If you are unsure about reporting taxes, please consult an accounting professional.

Editor’s Note: Underlying conditions remain bullish for investments such as MLPs. However, if you’re looking for a simpler way to generate income, consider high-quality dividend stocks.

Dividend-payers are time-proven vehicles for long-term wealth building, but they’re also safe havens because companies with robust dividends boast the strongest fundamentals. For our list of the best high-yielders, click here.