Understanding the tax consequences of the sale of an MLP interest is crucial. A basic understanding of the tax consequences helps to inform tax planning, leading to higher after-tax returns. It can also help guide the investor's MLP-related investment decisions in the first place. This Article provides a brief primer of a fairly complex subject: the sale of a partnership interest. It also makes a few tax planning suggestions, based on these consequences.
Sale of an MLP Interest: Tax Consequences
The sale of partnership interest can be broken down into two steps. First, the gain or loss must be calculated. Second, the gain or loss must be characterized. This assumes, of course, that the gain or loss is both realized and recognized.
Step 1: Calculating Gain/Loss
Calculating the gain or loss is fairly easy. Akin to other investments, you will realize a gain or loss equal to your Amount Realized minus your Adjusted Basis. At its simplest, your Amount Realized is simply the cash received on the sale (including any liabilities shed). The Adjusted Basis is your cost basis, which has been adjusted throughout the year to reflect distributions and your share of the MLP's income and liabilities. You can calculate your Adjusted Basis by simply adding the amount in your tax capital account to your share of liabilities (both of these values are found on the K-1).
Step 2: Characterizing Gain/Loss
Characterizing the gain or loss is more complex. Sadly, many investors wrongly assume that all of the gain/loss will be capital. This is far from true. Rather, I.R.C. 751 states that gain or loss is capital, "except as provided in section 751." As a result of section 751, a large portion of the gain/loss triggered on sale may be ordinary in character. The goal of 751 was to prevent people from stuffing ordinary income-producing assets into partnerships, merely to convert ordinary income into capital gains (i.e. absent 751, they could just sell the partnership interest and realize a capital gain, even if the partnership consisted predominantly of ordinary income-producing assets). In light of section 751, the character of the gain/loss is bifurcated as follows:
First, the sale of section 751 items trigger ordinary income upon sale (I.R.C. 751). The scope of 751 items is expansive and may result in a substantial amount of the gain/loss being treated as ordinary. Section 751 items include unrealized receivables, which are not yet included in income (I.R.C. 751(c)). Think of these as the right to payments for goods or services delivered (or to be delivered), which the partnership has not yet included in income. For example, it might include payments from customers, which have not yet been collected, if the partnership is a cash basis taxpayer.
Unrealized receivables also include amounts that would be subject to recapture at ordinary income rates (I.R.C. 751(c)). This includes, for example, depreciable personal property under section 1245 and depreciable real property under section 1250. Section 751 items also include inventory that the partnership holds (I.R.C. 751(d)). Inventory includes classic inventory, which is property held for sale to customers (I.R.C. 1221(1)). Section 751 inventory also encompasses all unrealized receivables as well, which are included in the partnership's income (see 751(d)). This is not an exhaustive list. Other items, not mentioned here, also fall within the scope of 751(c) and 751(d). The partner's share of the gain/loss from section 751 property, if all assets were sold at fair market value before the partner sold his interest, is characterized as ordinary (Treas. Reg. 1.751-1(a)).
Second, the 'excess'--the remaining part of the gain/loss, which isn't attributable to 751 items--is characterized as capital (I.R.C. 741). Notice that not all of this capital gain will receive the lowest, preferential rate. Rather, Treas. Reg. 1-(h)(1) contains a look-through rule. Basically, capital gains attributable to collectibles or Section 1250 property (such as depreciable buildings) will be taxed at rates higher than the lowest capital gains rate.
In sum, the sale of an MLP interest can result in an investor realizing a fair amount of ordinary income. It might also result in the taxpayer recognizing capital gain income, which is taxed at rates higher than the lowest capital gains rate. Tax planning, then, is important for any investor who wishes to minimize the effect of the ensuing taxes and maximize his real returns.
With these tax consequences in mind, here are a few planning tips:
Be intentional about when you choose to sell your interest in the MLP. Under Section 706, the partnership's taxable year closes vis-a-vis the seller when he sells his interest. Notice that this affects the timing of when the seller will include gains, losses, deductions, and other items in his basis. Put simply, the sooner you sell, the sooner you need to include these items in your basis (because the partnership's taxable year 'ends' sooner). Depending on (1) your inherent gain/loss in the MLP, (2) the outlook for the partnership for the remainder of the taxable year, and (3) the presence of any potentially offsetting losses, you may want wait before selling your MLP interest.
Consider holding MLPs in tax-deferred account(s). I write this grudgingly. While it allows you to avoid realizing ordinary income upon sale of the MLP, it leaves you vulnerable to UBTI. This is a well-trod subject, which I will not rehash here. Spreading MLPs across multiple tax-deferred accounts is one way to minimize (but not eliminate) the UBTI threat. Notice, however, that for those MLPs that generate losses, holding MLPs in a tax-deferred account is less than ideal. Part of the losses will presumably be ordinary, and yet you cannot enjoy these ordinary losses when the MLP is held in the IRA (or other tax deferred account).
It is somewhat frightening how much wrong information surrounds the tax treatment of MLPs. Make sure you understand the tax consequences of MLPs before you invest. Do your own research and/or consult a tax professional or a financial advisor. Not only will this help you understand your real returns (and maximize them through tax planning), but it will also help you make better investment decisions in the first place.
Disclaimer: This communication is for informational purposes only. As of this writing, the author is not an attorney or a certified financial planner or advisor. Any U.S. Federal Tax advice contained in this communication is not intended or written to be used, and cannot be used, for avoiding penalties under the internal revenue code or promoting, marketing or recommending to another party any tax-related matters addressed herein. This post is not intended as a solicitation or endorsement for legal services, and all data and all information is not warranted as to completeness and are subject to change without notice and without the knowledge of the author.