Income investors should have a diverse portfolio of tools in their arsenal. As my colleague John Persinos pointed out in a recent article, one of those is the real estate investment trust (REIT). These can provide steady income that are insulated from inflation.

Another important asset class that I want to discuss today is the master limited partnership (MLP). Specifically, I want to talk about the tax advantages of MLPs.

MLPs 101

For those unfamiliar with investing in MLPs, here’s a brief review.

In 1987, Congress legislated the rules for publicly traded partnerships in Internal Revenue Code Section 7704. To qualify as an MLP, at least 90% of an MLP’s income must come from qualified sources, such as real estate or natural resources.

An MLP issues units rather than shares. The big advantage for investors is that MLPs aren’t taxed at the corporate level. MLPs pass profits directly to unit-holders in the form of periodic distributions.

This arrangement avoids the double taxation of corporate income and dividends affecting traditional corporations and their shareholders and, all things being equal, should deliver more money to unit-holders.

But the distributions aren’t fully taxed either. Because of the depreciation allowance, conventional wisdom says that 80% to 90% of the distribution is considered a “return of capital” and thus not taxable when received. Instead, returns of capital reduce the cost basis of an investment in the MLP.

An IRS Agent Weighs In

However, a former IRS agent wrote to me last year to say that most people get the conventional wisdom is wrong. He argued that “All distributions of cash from MLPs are tax-free and not (as often stated) tax-deferred” until the cost basis of the investment reaches zero. In part, he wrote:

“All distributions are tax free because MLPs and all partnerships, do not make a physical distribution of income comparable to a dividend. Every item of Partnership income is distributed to partners in the form of a paper notification of the partner’s share of partnership income.”

He added:

“Why isn’t the distribution tax-deferred? Because when you receive a cash distribution it is literally a return of capital – A partial return of your original investment. Therefore, quite logically, you must reduce your cost basis for distributions received. The reduction in your basis fully accounts for any tax related treatment. There is nothing deferred because there is no accrual of a future tax liability associated with the distribution.

Yes, a distribution causes a dollar-for-dollar reduction in basis, but basis is subject to adjustments in both directions. A basis reduction via a cash distribution does not imply an imbedded future tax liability, and therefore not a ‘deferral’ of a tax liability. In fact, an MLP holder may choose never to sell their units and incur a tax reckoning.”

When you ultimately sell the MLP units or the cost basis drops to zero, a portion of the capital gain is taxed at the special long-term capital gains tax rate, and the remainder will be taxed at your normal income tax rate.

Of course, this kind of tax treatment provides a big advantage, since the income can be reinvested to generate compound returns that could more than pay for the eventual tax bill.

MLPs issue Schedule K-1 forms instead of the 1099 forms you may receive from a corporation, and the K-1 will reflect your share of the taxable income. Some K-1s aren’t issued until early April, which could delay your tax return.

I will go into more details on the mechanics of MLPs in a future article, but first I wanted to point out the important tax advantages of this class of asset.

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