Earn Huge Dividends -- and Shortchange Uncle Sam

No one likes paying taxes -- but a certain type of company has managed to stiff the taxman.

Master Limited Partnerships (MLPs) have a powerful tax advantage that most investors don't understand. If used properly, investors can generate large amounts of income while deferring taxes, as long as the investor doesn't sell the MLP. Read along, and I'll explain how you can use this advantage to reap income.

The secret of MLPs
An MLP is a legal structure that generally owns pipelines, resources, refineries, terminals, or other large assets related to natural resources, commodities, or real estate. Profit flows straight through the business untaxed, and gets paid to shareholders -- here known as unitholders -- as distributions from the business's cash flow. Unitholders are then responsible for paying their share of the partnership's taxes (even if the MLP is held in an IRA, which is not recommended). However, unitholders are taxed only on their share of the MLP's income, which is usually a much lower number than the amount of cash the business is bringing in.

Since an MLP's assets are generally very expensive, MLPs tend to have high depreciation (a non-cash charge to account for decline in an asset's value) for years. This charge lowers the MLP's net income, yet has no effect on the cash the business generates. For investors, this means you get cash now, but pay very little in taxes.

Let's see what this looks like:

Company

TTM Yield

Distributions per share

Income Per share

Taxes per share*

Kinder Morgan Energy Partners (NYSE: KMP  ) 6.1% $4.40 $1.41 $0.49
Cheniere Energy Partners LP (AMEX: CQP  ) 9.3% $1.70 $0.65 $0.23
Inergy LP (NYSE: NRGY  ) 7.1% $2.37 $1.71 $0.60
Buckeye Partners LP (NYSE: BPL  ) 6.4% $3.88 $1.66 $0.58
Linn Energy LP (Nasdaq: LINE  ) 6.8% $2.58 ($0.81) N/A
Penn Virginia Resource Partners LP  (NYSE: PVR  ) 6.9% $1.56 $0.95 $0.33
AmeriGas Partners LP (NYSE: APU  ) 6.1% $2.82 $2.72 $0.95

Source: Capital IQ, a division of Standard & Poor's. 
*Assuming 35% rate.

Assuming an income tax rate of 35%, an investor in Kinder Morgan Energy Partners last year would have received $4.40 per share while only paying $0.49 in taxes.

The taxman cometh
Nevertheless, the IRS is not a charity, and at some point you will have to make them whole. This happens when you sell the MLP. Normally, you have to pay capital gains on the difference between what you paid for a stock, called your cost basis, and what you sold it for. However, this process gets slightly more complicated with an MLP. (Don't worry too much: An MLP will send you a K-1 tax form every year laying out your taxes owed. Most tax software makes it easy to handle the form.)

First, every time you receive a distribution from an MLP, the IRS treats part of that distribution as a return of capital, thus lowering your cost basis by that amount. Second, the taxable MLP income is added to your cost basis, raising it by that amount. When you sell the MLP, you owe capital gains taxes on the difference between what you bought and sold the MLP for, like normal. You also owe income taxes on the difference between the adjusted cost basis and the price at which you purchased the MLP. Hypothetically, it would look like this, assuming income of $1 a year and distributions of $5 a year:

Cash Flows

Year 0

Year 1

Year 2

Year 3

MLP Purchase

$50.00

     

MLP Cost Basis

$50.00

$46.00

$42.00

$38.00

Income Tax From MLP Income ($1 x 35%)

 

($0.35)

($0.35)

($0.35)

Distributions

 

$5.00

$5.00

$5.00

MLP Sale

 

-

-

$60.00

Capital Gains Tax on Sale ($10 x 15%)

 

-

-

($1.50)

Income Tax on Sale ($12 x 35%)

 

-

-

($4.20)

Total Cash Flow

($50.00)

$4.65

$4.65

$58.95

As you can see, an MLP just defers taxes -- it doesn't cancel them. The advantage falls to the long-term investor who can defer taxes for decades, compounding the rewards of a seriously high dividend. One caveat, though: If your cost basis falls to zero, distributions are then immediately taxable. The government does not allow negative cost basis.

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Dan Dzombak can be found on his Twitter account: @DanDzombak. He does not own shares of any of the companies mentioned in this article.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (20) | Recommend This Article (56)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 18, 2011, at 11:34 AM, zorro6204 wrote:

    Pretty good, but you should mention that for upstreams, like LINE, a lot of the deductions that depress taxable income are in the form of "Intangible Drilling Costs" (IDC) and depletion, which are "recaptured" at the time of the sale as ordinary income, not capital gain. The MLP will supply that number at sale, in supplemental information with the K-1, but often it is vastly different than the actual deductions claimed. You can keep track on your own, but the task at least requires spreadsheet abilities. It also needs to be duplicated for AMT purposes.

    For midstreams and pipeline companies, depreciation can result in ordinary income, but the amount is much less because it's calculated based on the fair market value of the depreciated tangible property over its tax basis, and logically pipes and pumps do depreciate, they wear out, though probably not as fast as tax depreciation allows. You're rather at the mercy of the MLP's supplemental reporting at sale for this number, there's no practical way for a unit holder to calculate it.

  • Report this Comment On April 18, 2011, at 1:43 PM, HES wrote:

    What about buying mlp's in a Roth IRA ?

  • Report this Comment On April 18, 2011, at 1:56 PM, TMFDanDzombak wrote:

    Consult with a tax professional but in general, MLPs should not be purchased for an IRA (ROTH or Regular).

  • Report this Comment On April 18, 2011, at 7:50 PM, eddiejack100 wrote:

    Everone says not for IRA but they never give their reasoning,that would be helpfull sinse I owne arlp oks kmp

  • Report this Comment On April 18, 2011, at 11:33 PM, TMFDanDzombak wrote:

    Holding MLPs in a retirement account can result in the account owing taxes.

    Here's an explanation from the National Association of Publicly Traded Partnerships.

    http://www.naptp.org/PTP101/MLPs_Retirement_Accounts.htm

  • Report this Comment On April 19, 2011, at 10:55 AM, ByrneShill wrote:

    What about foreigners buying MLPs? Since the IRS doesn't retain taxes, we kinda end up off the hook?

  • Report this Comment On April 19, 2011, at 11:31 AM, energysystems wrote:

    Would KMR be an "IRA-friendly" alternative to KMP? I've been thinking of adding KMR to my retirement portfolio, but I'm not fully sure of it's tax implications. I still have another 35-40 years until I'd reach retirment age, so I'd have a long time to accumulate shares. Thanks guys.

  • Report this Comment On April 19, 2011, at 2:46 PM, MaxTheTerrible wrote:

    "Don't worry too much: An MLP will send you a K-1 tax form every year laying out your taxes owed."

    Yeah, good luck figuring out which forms you have to file based on IRS instructions!

    "Most tax software makes it easy to handle the form."

    You probably would have to pay extra for an "advanced" version of your favorite software bundle, since most basic packages do not handle K-1 (at least they did not used to 2 years ago)...

  • Report this Comment On April 19, 2011, at 4:49 PM, TMFTypeoh wrote:

    Dan,

    Very helpful information.

    I own a few MLP's, and knew they had tax advantages....but didn't know them this well.

    Thanks!

  • Report this Comment On April 19, 2011, at 4:59 PM, TMFDanDzombak wrote:

    @MaxTheTerrible I own BIP and TurboTax handled it without issue (Though it's a lot to input)

  • Report this Comment On April 19, 2011, at 4:59 PM, TMFDanDzombak wrote:

    @typeoh Thanks

  • Report this Comment On April 20, 2011, at 11:58 AM, wyknot wrote:

    Clarification for IRA / Roth IRA accounts receiving K-1's: Section 20 of the K-1, Code V, identifies Unrelated Business Taxable Income, not just "their share of the partnership's taxes" as stated in the article: "Unitholders are then responsible for paying their share of the partnership's taxes (even if the MLP is held in an IRA...." I've received information from my broker specifically on this area, i.e., Section 20, code V. It has to total more than $1K to be reported, per account, not per MLP, and the IRA custodian takes the money out of the account and remits it to the IRS.

  • Report this Comment On April 25, 2011, at 9:09 PM, 123spot wrote:

    Guys, this was great. Thanks Dan and wynot. I have been reading about them for 2 yrs and have never really understood them until this article. I bought ATLS in my Roth. My broker said, as I placed the order.ing only one K-1 "Oh, it's a limited partnership". After the research mentioned above, I realized my mistake, fortunately selling ATLS ater Chevron agreed to purchase it for cash and shares in another MLPA. I lucked out, having held only 1 yr and getting outof an MLP in a Roth and not going over the $1,000 UBTI. Still not sure if this ends up being a smart move in a taxable account; ultimately capital gains or income taxes on a sale would hit you at the worst time. If you never sold, it seems as if your heirs end upp with a tax basis of 0 and are disadvantaged.

  • Report this Comment On June 01, 2011, at 4:43 PM, whyaduck1128 wrote:

    The calculated gain on sale is incorrect. The gain is stated to be $18, which means $42 is the basis. Actually, the basis is $42 plus Year 3's income of $1 less Year 3's distributions of $5, or $38.

  • Report this Comment On September 08, 2011, at 11:35 AM, 1Robinet wrote:

    On April 19th, Byrneshil asked:

    "What about foreigners buying MLPs? Since the IRS doesn't retain taxes, we kinda end up off the hook?"

    I haven't found an answer --- do you have one?

  • Report this Comment On November 02, 2011, at 5:18 PM, glassbd86 wrote:

    Caveat: I'm not an individual tax expert, and this should be construed as specific tax advice, but the risk to foreign investors would be withholding tax. Absent treaty benefits or individual elections, the MLP will withhold 30% of the dividends paid to foreign persons.

  • Report this Comment On November 03, 2011, at 7:34 AM, HomebrewJunkie wrote:

    I liked the article and the responses very much.

    This isn't the first time I've read about tax implications of MLPs (and I doubt it will be the last) but I never seems to fully understand it.

    I do hold KMR, NSH, SE in an IRA.

    I think these versions are not classed as MLPs and therefore I don't need to worry about K1's etc. BUT I would welcome any information about this - especially to the contrary.

    I also bought the ETF AMLP in my IRA.

    This ETF holds a bunch of MLPs and I would like to know if there are ANY similar tax implications with holding this ?

    Many Thanks for any information you can provide.

  • Report this Comment On December 02, 2011, at 7:11 PM, susantwentyeight wrote:

    Has anyone here ever SOLD an MLP from an IRA, and if so, how is the tax treated? UBTI from the cost basis reduction (since it originally came from non-passive income) but the capital gain between purchase and sale price is still protected by the IRA, or what?

  • Report this Comment On June 05, 2012, at 8:07 PM, mcseberger wrote:

    I bought shares of KMR, the stock dividend version, in April 2009, for my Roth. I never received any yearly statement from Etrade. Then I sold the shares in July 2011. At the end of year the sale was reported on the 1099-B along with the accumulated dividend shares.

  • Report this Comment On June 05, 2012, at 8:56 PM, mcseberger wrote:

    Correction to previous posting. Shares of KMR were sold for a longterm capital gain from a Roth and from a taxable account last July. I never received any 1099-B nor a K-1 for the shares in the Roth. A 1099-B was received for the taxable account of the original shares purchased and the accumulated dividend shares received. Sorry about the error.

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