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I’ve written about master limited partnerships [MLPs] extensively in Personal Finance and in the dedicated MLP advisory service I co-edit with Roger Conrad, MLP Profits.

The group boasts three main attractions: high yields, growing distributions and tax-deferral advantages. The average MLP in the benchmark Alerian MLP Index currently offers a yield just under 7 percent, and several offer payouts of more than 10 percent.

Only a handful of MLPs have actually cut their distributions over the past two years, despite the fact that troubled credit markets and plummeting demand for energy commodities were headwinds in late 2008. The credit crunch and the Great Recession were key stress tests that the MLP sector passed.

Finally, the group offers major tax advantages. The reason is that a good portion of the income you receive from MLPs is considered a return of capital, which isn’t immediately taxable. Instead, RoC reduces your cost basis in an MLP and isn’t taxed until you sell your units.

Roger and I are often asked if there’s a potential for the Obama administration to change the tax laws governing MLPs such that they lose their significant tax-deferral advantages. Although there’s no such thing as complete certainty in politics, there’s no sign of a change on the horizon.

Unfortunately, there is a great deal of misinformation published on the Internet and in print media concerning MLP taxation. Back in 2007 a series of articles published in major media outlets claimed that Congress was working on legislation to end the MLP tax advantage.

The same rumors have cropped up again lately because of an editorial published recently in The Wall Street Journal and quoted elsewhere. In both cases, these articles have been referring to a complex tax issue known as “carried interest.” The bottom line is that the energy-focused MLPs we recommend would not be adversely affected by the proposed tax changes and, in fact, may benefit.

Here’s the real story.

On Dec. 9, 20009, the US House of Representatives passed The Tax Extenders Act of 2009 (HR 4213). The bill extends certain tax benefits to individuals and businesses but includes language that would mean that all carried interest income is taxed at ordinary income tax rates rather than lower capital gains rates.

The same basic language was included in the Treasury Dept’s Green Book, a document that explains at great length the Obama administration’s tax proposals for the year ahead. The following passage from the Green Book describes the current law:

A partnership is not subject to federal income tax. Instead, income and loss of the partnership retains its character and flows through to its partners, who must include such items on their tax returns. Generally, certain partners receive partnership interests in exchange for contributions of cash and/or property, while certain partners (not necessarily other partners) receive partnership interests, typically interests in future profits (“profits interests”) in exchange for services. Accordingly, if and to the extent a partnership recognizes long-term capital gain, the partners, including partners who provide services, will reflect their shares of such gain on their tax returns as long-term capital gain. If the partner is an individual, such gain would be taxed at the reduced rates for long-term capital gains. Gain recognized on the sale of a partnership interest, whether it was received in exchange for property, cash or services, is generally treated as capital gain.

This statement refers to carried interest, a form of compensation paid to a partnership’s managers in exchange for their services. For the publicly traded MLPs, carried interest includes the incentive distribution rights [IDR] the limited partners pay to their general partners [GP].. We’ve explained the GP-LP relationship at great length before in PFW, including in the Oct. 10, 2009 issue, Strong Parents Make Healthy MLPs.

Here’s where it gets a bit complicated. Carried interest paid to general partners represents a share in the income produced by the partnership and is taxed accordingly. Thus, if that carried interest is generated by buying and selling financial assets such as stocks and bonds, it could represent capital gains rather than ordinary income. Under the current law, those managers receiving carried interest earned through capital gains would be taxed at the lower capital gains tax rate.

This doesn’t apply to the energy MLPs. Energy MLPs represent operating businesses; the carried interest income they generate isn’t capital gains and has always been taxed at ordinary income tax rates. Managers don’t pay the lower capital gains tax rates on their IDRs at the current time, so this law wouldn’t affect their taxation one bit.

Note that this has nothing at all to do with those of us who are MLP unitholders, owning the units of the MLPs we recommend. As MLP unitholders we don’t receive carried interest income as part of our regular quarterly distributions, so this doesn’t represent a change to the way we’re taxed.

There is one exception: the publicly traded MLPs of companies involved in the private equity and investment management businesses. That list includes AllianceBernstein (NYSE: AB), Fortress Investment Group (NYSE: FIG), Icahn Enterprises (NYSE: IEP), KKR Financial Holdings (NYSE: KKR), Lazard(NYSE: LAZ), and Och-Ziff Capital Management (NYSE: OZM). Because these firms do generate carried interest from financial activities, their managers have been taxed at lower capital gains rates on some of the carried interest they receive. These managers could face a higher tax bill if the law is passed.

To make matters worse, the House legislation includes a provision that explicitly says that publicly traded partnerships that provide investment management services will no longer be eligible for partnership tax treatment; these firms would no longer be able to be taxed like MLPs. No new investment management partnerships would be allowed to list, and those already in existence would be given 10 years to change their structure.

That the administration is targeting private equity/investment partnerships, both those that are publicly traded and those that aren’t, specifically is evident from this passage from the Green Book:

By allowing service partners to receive capital gains treatment on labor income without limit, the current system creates an unfair and inefficient tax preference. The recent explosion of activity among large private equity firms has increased the breadth and cost of this tax preference, with some of the highest-income Americans benefiting from the preferential treatment.

Since we started MLP Profits we’ve repeatedly noted that these financial partnerships are in the Obama administration’s crosshairs and that the risk of this sort of legislation loomed. That’s why we’ve rated all of these partnerships “Sell” in our How They Rate table.

The current consensus in Washington is that there aren’t enough votes in the Senate to pass this particular legislation. But the carried interest provision could be reintroduced in another bill if it doesn’t pass this time around. This is another chance to get out of the investment management partnerships if you haven’t already.

There are two additional points worth noting. First, the Obama administration has proposed raising taxes on dividend income. Because MLPs don’t pay dividends, such a change would actually make them more attractive to investors because they’d become even more tax-advantaged relative to dividend paying stocks.

Second, by addressing the carried interest issue and specifically targeting investment management partnerships, Congress has implicitly signaled continued support for the partnership structure as it applies to energy-focused MLPs.

If you’re interested in reading more about carried interest and the House legislation, check out the National Association of Publicly Traded Partnership [NAPTP] website. The NAPTP represents publicly traded partnerships’ interests in Washington and has been closely involved and consulting with Members of Congress involved in the writing of this and other bills. The NAPTP has published a useful question-and-answer document on the carried interest issue that summarizes the same basic points I just outlined.

Author's Disclosure: No Positions

Source: A Closer Look at Master Limited Partnerships and Taxation