MLPs -- Part 7: MLP Investor Taxation

Includes: AMJ, AMLP, EPD
by: Richard Shaw

This is Part 7 in our series on Master Limited Partnerships, with a primary focus on those that are midstream, liquid energy gathering, processing, transport, and storage. This Part 7 is about taxation of investors in MLPs.

We are not tax advisors, so that is merely a compilation of tax related statements published by entities who are in a reasonable position to make useful and potentially reliable statements about investor taxation. We do not express any tax opinion on our own by this presentation.

Earlier articles on MLPs can be accessed with these links:

Part 1: Identifying the Public Master Limited Partnerships (08/06/10)

Part 2: MLP Total Return and Statistics vs Stocks and Bonds 08/09/10)

Part 3: Return Correlation Between MLPs, Stocks and Bonds (08/10/10)

Part 4: The Most Liquid MLPs (08/10/10)

Part 5: MLPs Passing Fundamental Screen (08/13/10)

Part 6: MLP Structure and IRS Qualification (08/22/10)


Tax Discussion From National Association of Publicly Traded Partnerships

Owning units (shares) in an MLP is different from owning corporate stock in a number of ways, most notably their taxation. That is because an MLP is a partnership, and you, as an investor, are a limited partner. To understand how an MLP investor is taxed, it helps to know the basic principles of partnership taxation.

Partnership Tax Basics: Income

  • An MLP, like all partnerships, is a pass-though entity which pays no tax itself. It is treated by the tax code not as a separate entity but as a collection of partners.
  • The unitholder, as a limited partner, is treated for tax purposes as if he is directly earning the MLP’s income.
  • Each unitholder is allocated on paper a proportionate share of the MLP’s income, gain, deductions, losses, and credits. This is reported annually on the K-1 form.
  • The unitholder calculates his share of taxable income and pays tax on it at his own tax rate. The tax is owed whether or not the unitholder receives a cash distribution.

Partnership Tax Basics: Distributions

  • The quarterly cash distributions are not the same as your share of the MLP’s income.
  • Under the tax code, the distributions are a return of capital and are not taxed when received.
  • Your basis in your partnership units (the amount you paid, increased or decreased by various adjustments) is lowered by the amount of the distribution.
  • Thus, when you sell your units, your taxable gain (sales price minus adjusted basis) is increased by the amount of the distributions.
  • Often you will hear someone say that “80% (or a similar number) of the MLP’s distribution is tax-deferred.” As long as your distribution is less than your basis, it is 100% tax-deferred. What they mean is that your share of the MLP’s net taxable income equals about 20% of the tax-deferred distribution.

Basis Adjustments

  • Basis is used to determine your gain or loss when you sell your units.
  • Your initial basis is the price you paid for your units.
  • Your cash distributions adjust your basis downwards.
  • Your share of taxable partnership income each year adjusts the basis upwards.
  • Your share of deductions like depreciation adjusts it downwards.

Basic Tax Principles for MLP Investors

This fact sheet is for informational purposes only and should not be construed as offering tax advice. Consult your tax advisor regarding your own situation.

  • As long as your adjusted basis is above zero, tax on your distributions is deferred until you sell your units. If it reaches zero, future cash distributions will be taxed as capital gain in the year received.
  • If a unitholder dies and the units pass to his heirs, the basis is reset to the fair market value of the units on the date of death, and the prior distributions are not taxed.

Gain and Recapture

  • When you sell your MLP units, your taxable gain is the difference between the sales price and your adjusted basis.
  • Not all of the gain when units are sold is taxed at capital gains rates.
  • The gain resulting from basis reductions due to depreciation is taxed at ordinary income rates—this is called “recapture.”
  • Gain attributable to your share of some types of assets held by the MLP—substantially appreciated inventory and unrealized receivables—is also taxed as ordinary income.
  • These items will be reported on the K-1 for the year in which you sell your units.


Selected Portions of Tax Risks from Enterprise Products Partners 10-K

Tax Risks to Common Unitholders

Our tax treatment depends on our status as a partnership for federal income tax purposes, as well as our not being subject to a material amount of entity-level taxation by individual states. If the Internal Revenue Service were to treat us as a corporation or if we were to become subject to a material amount of entity-level taxation for state tax purposes, then our cash available for distribution to our common unitholders would be substantially reduced.

The anticipated after-tax economic benefit of an investment in our common units depends largely on our being treated as a partnership for federal income tax purposes. We have not requested, and do not plan to request, a ruling from the Internal Revenue Service (“IRS”) on this matter.

If we were treated as a corporation for federal income tax purposes, we would pay federal income tax on our taxable income at the corporate tax rate, which is currently a maximum of 35%. Distributions to our unitholders would generally be taxed again as corporate distributions, and no income, gains, losses, deductions or credits would flow through to our unitholders. Because a tax would be imposed upon us as a corporation, the cash available for distribution to our common unitholders would be substantially reduced. Thus, treatment of us as a corporation would result in a material reduction in the after-tax return to our common unitholders, likely causing a substantial reduction in the value of our common units.


Tax Discussion From AMLP Prospectus

Tax Status of the Fund. The Fund is taxed as a regular corporation for federal income tax purposes. This differs from most investment companies, which elect to be treated as “regulated investment companies” under the Code in order to avoid paying entity level income taxes. Under current law, the Fund is not eligible to elect treatment as a regulated investment company due to its investments primarily in MLPs invested in energy assets. As a result, the Fund will be obligated to pay applicable federal and state corporate income taxes on its taxable income as opposed to most other investment companies which are not so obligated. As discussed below, the Fund expects that a portion of the distributions it receives from MLPs may be treated as a tax-deferred return of capital, thus reducing the Fund’s current tax liability. However, the amount of taxes currently paid by the Fund will vary depending on the amount of income and gains derived from investments and/or sales of MLP interests and such taxes will reduce your return from an investment in the Fund.

Deferred Tax Liability. Cash distributions from an MLP to the Fund that exceed such Fund’s allocable share of such MLP’s net taxable income are considered a tax-deferred return of capital that will reduce the Fund’s adjusted tax basis in the equity securities of the MLP. These reductions in such Fund’s adjusted tax basis in the MLP equity securities will increase the amount of gain (or decrease the amount of loss) recognized by the Fund on a subsequent sale of the securities. The Fund will accrue deferred income taxes for any future tax liability associated with (i) that portion of MLP distributions considered to be a tax-deferred return of capital as well as (ii) capital appreciation of its investments. Upon the sale of an MLP security, the Fund may be liable for previously deferred taxes. The Fund will rely to some extent on information provided by the MLPs, which is not necessarily timely, to estimate deferred tax liability for purposes of financial statement reporting and determining the net asset value (“NAV”). From time to time, ALPS Advisors, Inc. (the “Investment Adviser”) will modify the estimates or assumptions regarding the Fund’s deferred tax liability as new information becomes available. The Fund will generally compute deferred income taxes based on the federal income tax rate applicable to corporations currently 35% and an assumed rate attributable to state taxes.

Returns of Capital Distributions From the Fund Reduce the Tax Basis of Fund Shares. A portion of the Fund’s distributions are expected to be treated as a return of capital for tax purposes. Returns of capital distribution are not taxable income to you but reduce your tax basis in your Fund Shares. Such a reduction in tax basis will result in larger taxable gains and/or lower tax losses on a subsequent sale of Fund Shares. Shareholders who periodically receive the payment of dividends or other distributions consisting of a return of capital may be under the impression that they are receiving net profits from the Fund when, in fact, they are not. Shareholders should not assume that the source of the distributions is from the net profits of the Fund.


Tax FAQs About AMJ From JP Morgan ETN Website

What is the tax treatment of the ETNs?

As more fully described in the relevant pricing supplement and product supplement, we believe it is reasonable to treat the ETNs as “open transactions” for U.S. federal income tax purposes.

Will investors in the ETNs receive Schedule K-1s?

No. Investors in the ETNs will not receive a Schedule K-1 by virtue of their Investment in the ETNs.

What is the tax treatment of the coupons for U.S. holders?

As more fully described in the relevant pricing supplement and product supplement, the Issuer and investors in the ETNs agree to treat the coupons as ordinary income at the time accrued or received, in accordance with the investor’s method of accounting for U.S. federal income tax purposes. It is expected that a broker or custodian (or entity through which an investor holds his or her interest in the ETNs) will report the coupons paid on the ETNs as ordinary income on Form 1099-MISC.

Why does the tax treatment of the coupons paid on the ETNs differ from the tax treatment of the cash distributions made by MLPs?

Investors in the ETNs do not hold direct interests in the MLPs underlying the Index. Investors in the ETNs hold senior, unsecured obligations of J.P. Morgan Chase & Co. that provide synthetic exposure to the Alerian MLP Index.

What is the tax treatment upon sale, exchange or redemption of the ETNs for U.S. holders?

As more fully described in the relevant pricing supplement and product supplement, assuming the ETNs \are treated for U.S. federal income tax purposes as “open transactions” with respect to the Index and not as debt instruments, upon a sale or exchange (including early repurchase or redemption at maturity) of the ETNs, if you are a U.S. holder (as defined in the product supplement), you should recognize gain or loss equal to the difference between the amount realized on the sale or exchange and your tax basis in the ETNs, which should equal the amount you paid to acquire the ETNs. This gain or loss should be capital gain or loss, subject to the discussion of the “constructive ownership” rules provided in the relevant pricing supplement and product supplement, and should be long-term capital gain or loss if you have held the ETNs for more than a year.

Holdings Disclosure: As of January 20, 2011 we hold positions in some but not all managed accounts for the following securities mentioned in this article: EPD, AMJ

Disclaimer: Opinions expressed in this material and our disclosed holdings are as of January 20, 2011. Our opinions and holdings may change as subsequent conditions vary. We do not make any commitment to publish or provide any public notice of future changes to our opinions or changes in our holdings.

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