Income investors have faced a huge problem lately: how do you generate income from an investment portfolio with extremely low interest rates? In order to find new sources of income, investors have had to turn to exotic types of investments. Master limited partnerships in particular have gained popularity, as their exposure to the energy sector and their healthy payouts were especially attractive during the oil boom.
Yet as those investors discovered at tax time, investing in MLPs usually brings with it the need to deal with Schedule K-1 -- a tax form that is a notorious nightmare for income investors. Let's take a closer look at Schedule K-1, and see why so many income investors treat it as their worst enemy.
Schedule K-1 and you
Most investors are used to dealing with the tax consequences of regular dividends. Your broker typically sends you a 1099-DIV form that lists the dividends you've received from your stocks, and you simply report those dividends as income on your tax return. That simple process works well, and ensures that the IRS gets the money it's due without unnecessary complications.
MLPs and other partnerships, however, work differently from most stocks. Tax law allows MLPs to avoid having to pay tax at the business-entity level, which gives them an advantage over regular corporations that have to pay corporate tax. The trade-off, though, is that MLPs have to pass through any income they earn to their owners. Even if a partnership doesn't end up paying out income, those requirements force MLP investors to include portions of income on their tax returns.
The way that MLPs inform their investors about the income they've earned is by sending out the information on Schedule K-1. As you can see in the image at the top of the article, the K-1 tells you how much income the partnership earned, breaking it down into numerous categories including interest, dividends, royalties, capital gains, and ordinary business income. You'll also find your share of deductible expenses, credits, and other tax benefits that you can claim on your tax return under certain circumstances.
Why investors hate Schedule K-1
There are a couple of big reasons why MLP investors find Schedule K-1 problematic. First, the form often requires that you take several different numbers and include them in various places within your regular tax return. That's a far cry from the simplicity of just putting your total dividends from regular stocks on a single line, and with many complex and often misunderstood forms involved, it can be hard to figure out exactly what to do with all the figures on your K-1. In particular, entries like the percentage interest in the overall partnership, capital account balances, and other partnership-specific concepts are often unclear for many investors, and it can be difficult even to figure out how or whether you need to report all the information that the K-1 provides.
The other big hassle with Schedule K-1 is that different companies are inconsistent about when they send the forms out to their investors, which can cause delays in your ability to file your tax return when you want. Since a partnership's own tax returns often aren't due until April 15, some partnerships don't even send out Schedule K-1 forms until just before their investors' own tax-filing deadline. Moreover, because incorporating Schedule K-1 information into your overall tax return isn't trivial, getting extensions to file is a simple fact of life for many investors in MLPs and other partnerships.
Schedule K-1 is rightly seen as a hassle, especially for those who are used to having a simplified process for getting their tax returns done. For those who want the income potential from MLPs and other partnerships, though, dealing with Schedule K-1 is a price you pay to open the door to higher distributions from your investment portfolio.