Editor’s Note: The following should be construed as information only and not tax advice. For advice on the tax implications, federal and state, of holding units of publicly traded partnerships (PTP), publicly traded master limited partnerships (MLP) or publicly traded limited liability corporations (LLC) in your regular or retirement account please consult your tax advisor or your tax attorney.

Master limited partnerships (MLP) are registered as limited partnerships, which traditionally was the form of organization for law firms, accounting firms, film production companies, finance firms and real estate investment projects or in types of businesses that focused on a single or limited-term project.

To qualify for MLP status a partnership must generate at least 90 percent of its income from what the Internal Revenue Service (IRS) deems “qualifying” sources. These include activities related to the production, processing or transportation of oil, natural gas and coal.

A partnership is not itself subject to federal income taxation under present law. Rather, each partner takes into income his or her distributive share of the partnership’s taxable income and the separately computed items of income, gain, loss, deduction or credit of the partnership.

Liability for federal income tax payment is that of the partner, not of the partnership. A partnership is treated as a conduit, or a “pass-through,” because income and loss of the entity is normally taken into account directly by the owners.

Traditional corporations aren’t treated as conduits for tax purposes. Income or loss of a corporation is taken into account for tax purposes at the corporation level and determines the corporation’s tax liability.

Distributions–or dividends paid–by corporations to their shareholders are separately subject to tax in the hands of the shareholders in determining their own tax liability.

Income of corporations is thus subject to two levels of tax, once at the corporate level when earned by the corporation and again at the shareholder level when the corporation pays dividends to them.

MLPs also trade publicly, which places them on similar footing to more familiar corporations. But MLPs avoid the double taxation suffered by shareholders who receive dividends from corporations.

No tax at the entity level allows MLPs to maximize distributions to investors; this is the main attraction of publicly traded partnerships for individual investors.

Ownership of an MLP is expressed in terms of “units” rather than “shares,” as is the case with corporations. As an MLP owner you, the investor, are a limited partner. The MLP itself pays no tax; you, the unitholder and limited partner, are deemed for tax purposes to have earned the MLP’s income, as this income (or loss) has “passed through” to you.

You, as a unitholder and limited partner, are allocated on paper a proportionate share of the MLP’s income, gain, deductions, losses and credits.  This is reported annually on the K-1 form.

Distributions from a partnership to a unitholder generally don’t give rise to recognition of gain or loss to the unitholder or to the partnership. Your cost basis in your partnership interest is reduced by the amount of money distributed to you. Distributions in excess of your basis do, however, result in a gain.

Although current distributions to unitholders aren’t generally taxable to your, according to current law you include in your income your distributive share of partnership taxable income, whether or not you receives any corresponding distribution. You also take account of separately computed items of partnership gains, losses, deductions or credits, reflecting the conduit nature of partnerships.

In practice, publicly traded partnerships generally limit income attributable to you as a unitholder.

Quarterly cash distributions aren’t the same as your share of the MLP’s income. Under the Internal Revenue Code partnership distributions are a return of capital (ROC) and aren’t taxed when received. Your basis in your partnership units (the amount you paid, increased or decreased by various adjustments) is lowered by the amount of the distribution.

As long as your distribution is less than your basis, it is 100 percent tax-deferred. When you sell your units, your taxable gain (sales price minus adjusted basis) is increased by the amount of the distributions.

There are no legal obstacles to holding MLPs in tax-advantaged accounts such as IRAs. However, holding tax-advantaged MLPs in a tax-sheltered account isn’t the most efficient use of your capital.

Additionally, the Internal Revenue Service (IRS) classifies some income generated by MLPs held in IRAs as unrelated business taxable income (UBTI). That means if total income–not the distributions–associated with one or more MLPs exceeds USD1,000 the plan administrator will be forced to file a return and pay an unrelated business income tax (UBIT) from available funds.

Here is a brief summary of relevant MLP taxation points:

• Basis is used to determine your gain or loss when you sell your units.
• Your initial basis is the price you paid for your units.
• Your cash distributions adjust your basis downwards. 
• Your share of taxable partnership income each year adjusts the basis upwards.
• Your share of deductions such as depreciation adjusts it downwards.
• These items are reported to you on an annual basis on the K-1 form generated by each MLP in which you hold units.
• As long as your adjusted basis is above zero, tax on your distributions is deferred until you sell your units.
• If your basis reaches zero, future cash distributions will be taxed as capital gain in the year received.
• If you die and your units pass to your heirs, the basis is reset to the fair market value of the units on the date of death, and the prior distributions aren’t taxed.
• When you sell your MLP units, your taxable gain is the difference between the sales price and your adjusted basis.
• Not all of the gain when units are sold is taxed at capital gains rates.
• The gain resulting from basis reductions due to depreciation is taxed at ordinary-income rates; this is called “recapture.”
• Gain attributable to your share of some types of assets held by the MLP–substantially appreciated inventory and unrealized receivables–is also taxed as ordinary income.
• These items will be reported to you on the K-1 form for the year in which you sell your units.