There is a class of high-yield investment you might not have heard about: master limited partnerships, or MLPs. This kind of investment is renowned for its high and potentially fast-growing yield, and it can also return superior total returns over time. However, before investing in this asset class there are certain tax ramifications, both good and bad, that potential MLP investors need to be aware of. Let's review what they are and how you can adjust your portfolio accordingly to build both wealth and income over time. 

MLPs made simple
MLPs are publicly traded limited partnerships that must legally derive at least 90% of their cash flows from real estate, natural resources, or commodities.  

Here's a glance at the major differences between corporations and MLPs:

 CharacteristicCorporationMLP
Retain earnings for growth? Yes No
Do investors have a say in running the company? Yes No
Ownership form? Shares Units
What does it pay investors? Dividends Distributions
How is it taxed? Qualified dividend/taxable income Return of capital
Which tax form? 1099 K-1
Appropriate for tax-deferred accounts? Yes Not if you want full tax benefits
Preferential tax treatment? No Yes

Sources: Morningstar.com, Investopedia.

MLPs are pass-through entities, meaning they don't pay taxes on their earnings as long as they pass the vast majority of them on to investors as distributions. Typically 80% to 90% of the distribution is in the form of return of capital, or ROC, which is a fancy way of saying that, thanks to numerous write-offs and depreciations the partnership takes on its equipment, most of your payout is tax deferred. The exact breakdown of taxable income versus ROC is shown in the K-1 form, which the partnership sends out to all investors annually.

Since the biggest differences between corporations and MLPs comes at tax time to decide whether MLPs are right for you, there are three things you need to consider.

Fact one: More complicated tax preparation
The K-1 is often considered a major downside to owning MLPs, because it can complicate tax preparation. Fortunately, accountants and software such as TurboTax can make this process far less arduous. 

Another thing to know about MLP taxes is that owning one in a tax-deferred account such as an IRA can be suboptimal because of UBTI, or unrelated business taxable income, which is something MLPs can sometimes generate during their operations. If your holdings are big enough that your total UBTI tax bill (per your K-1) is over $1,000, then you'll need to pay taxes on that UBTI income, even though the MLP is held in a tax-deferred account. 

Fact two: Major tax benefits
You might be wondering, with all the added tax hassles, why anyone invests in MLPs. Well, for two main reasons. First, they're known for high, growing, and sustainable yields -- as high as 13% and some MLPs, such as Linn Energy, (NASDAQ: LINE) pay monthly distributions.

The second reason has to do with the tax benefits of MLPs. The way ROC works is that rather than pay taxes right away, you deduct them from your cost basis. Then when you sell units of MLPs, you pay taxes on your units sold. This can have a powerful long-term benefit. For example, say you invested $10,000 in an MLP. If you hold the units long enough, eventually your cost basis will go to $0. As long as you don't sell, then $10,000 of otherwise taxable income will be permanently deferred from the IRS. You can pass on MLP units to your heirs, and as long as they don't sell them, they don't have to pay taxes, either. However, this only applies as long as your cost basis is above zero.

As a result of these tax benefits, MLPs get a bit more complicated. For example, if you do sell your units of an MLP, some of the profit will be taxed as long-term capital gains, and some will be "recaptured" (taxed as ordinary income). This includes things like depreciation, inventory appreciation, and unrealized receivables. This information can be found in the annual K-1 your MLP will send you.

What about after your cost basis has hit zero? Then most of the ROC is taxed as long-term capital gains. Herein lies the true benefit of MLPs, because long-term capital gains taxes are much lower than regular income tax levels.

Tax BracketLong-Term Capital Gain Tax Rate
10% 0%
15% 0%
25% 15%
28% 15%
33% 15%
35% 15%
39.60% 20%

Source: Moneychimp.com.

For the vast majority of investors, the capital gains taxes paid on income earned by MLPs, once the cost basis has hit zero, is 0% or 15%. Even if you're in the top tax bracket, you end up paying half the tax rate compared with what you would pay if distributions were taxed as ordinary income. 

Fact three: Complications with owning MLPs in retirement accounts
What if you want to own MLPs in a tax-deferred account such as an IRA or 401(k)? While you sometimes can do this, there are several things to keep in mind.

First, some brokers won't allow MLPs to be owned in such accounts, so check with your broker to see if they have such limitations. 

Second, because tax-deferred accounts are already offsetting your income taxes, the tax benefits of MLPs are largely wasted, which is why many financial advisors recommend owning MLPs in taxable accounts to maximize their tax benefits.

Third, as long as your total account UBTI is under $1,000 then your retirement account won't generate any extra taxes. However, any UBTI above $1,000 must be declared and is taxed at 39.6% (the highest marginal tax rates applied to trusts).

Finally, there are several alternatives to MLPs that can be owned in retirement accounts that allow you to experience the high-yield, dividend growth benefits of these partnerships without the tax headaches.

The key is that the investments need to be regular corporations, which won't give you any of the deferred tax benefits of an MLP. One such example is LinnCo (NASDAQ: LNCO), which exists purely to own units of Linn Energy and uses its distributions to pay regular monthly dividends. As it's a regular corporation, you can own it in a tax-deferred retirement account because it doesn't incur any UBTI.

Another way to own MLPs in a retirement account without incurring UBTI is with MLPs that pay distributions in the form of shares instead of cash. These MLPs are usually structured to own units of an affiliated MLP and sometimes manage its assets. One example of such an MLP is Enbridge Energy Management LLC (NYSE: EEQ), which manages (and owns 17% of) Enbridge Energy Partners (NYSE: EEP) that currently pays a stock dividend equal to a yield of 6.21%.  

Bottom line
MLPs can make some of the best income investments you can buy. However, investors need to be aware of the three biggest tax ramifications of owning these assets which are: more complicated tax preparation, complications with owning them in retirement accounts, and the need to hold them for many years to maximize their full tax benefits. If you're interested, I recommend you research the MLPs and companies mentioned here, as well as take a look at the free report below.

 

Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Enbridge Energy Partners. Try any of our Foolish newsletter services free for 30 days. 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.