Publicly traded partnerships have been popular with income-oriented investors for many years, yet few holders have an understanding of how to report these entities on an income tax return. The purpose of this article is to present enough information on the topic to allow an individual investor who is not a tax practitioner to gain a conceptual understanding of the topic. Note that this article is only focused on partnership interests held in non-retirement accounts. The issues raised by ownership of these entities in retirement accounts, such as IRAs, have been discussed at length in other articles. See Master Limited Partnerships and Your IRA from contributor Reel Ken, which, putting it mildly, drew a lot of interest.
As defined by the National Association of Publicly Traded Partnerships (NAPTP):
"publicly traded limited partnerships (PTPs) are commonly known as Master Limited Partnerships (MLPs). These entities are limited partnerships or limited liability companies (LLCs) which have chosen partnership taxation, and are traded on public exchanges. A share in an MLP is called a unit, and MLP shareholders are known as unitholders. MLPs can be found on the New York and NASDAQ exchanges, as well as many regional exchanges. They combine the affordability and liquidity of corporate stocks and bonds with the advantages of investing in a partnership. MLPs generally pay their investors regular cash distributions, and many offer growth potential as well. There are over 100 MLPs on the market, the majority in industries related to energy and natural resources."
Note that for purposes of clarity, throughout this article the terms "units" and "shares" will be used interchangeably, as will the terms "unitholders" and "shareholders", with the understanding that for limited partners of an MLP, the terms refer technically to "units" and "unitholders". Further, the terms "PTP" and "MLP" will likewise be used interchangeably throughout the text.
For an introduction to MLPs, refer to my earlier article, Yield, Value, Safety, and Complications with MLPs, as well as the NAPTP link provided above.
Partnerships, unlike corporations, do not pay taxes, but instead "pass through" all activity to their partners, who report their share of the partnership's activities as appropriate on their individual tax returns. The partnership is not, however, excused from an annual accounting to the IRS. A partnership return (Form 1065) must be filed annually, detailing all activity for the partnership. Each partner's share of the partnership's activities is included in the annual partnership filing, and is reported on a separate Form K-1, one for each partner, which shows the partner's percentage share of each item, based on the partner's percentage of ownership. This form is also sent to each partner, to be used to report the partner's share of the partnership's activities on the partner's individual tax return. Since all of the K-1s sent to the individual partners are also included in the partnership filing with the IRS, the IRS has a copy of all of the K-1s issued to the partners. As can be imagined, with thousands of owners, or partners, the items reported on an individual's K-1 are relatively small numbers, unless the ownership is substantial. In fact, since only whole numbers are shown on the K-1, rounding frequently causes some numbers reported to be zero. Thus, if a zero is on the K-1 for an item, it means there was activity for that item at the partnership level, but the partner's share rounded down to zero. No matter how small, other than zero items, the items on the K-1 are required by law to be reported correctly on the partner's tax return, which will require numerous tax forms beyond those normally required for investors in stocks. The cost of tax preparation alone can frequently outweigh any advantages of partnership ownership for small investors.
There are several material differences, other than terminology, between owning shares of stock of a corporation and owning units of an MLP. While dividends from a corporation are classified as qualified or non-qualified, and are reported on the tax return on Schedule B and Form 1040, distributions from an MLP are not reported at all, and are actually not taxable income. When you consider that fact, plus the historically high yields of most MLPs, it is no wonder that these entities have been popular with income investors. The major downside of MLPs is the complexity of reporting and recordkeeping for owners of partnership units. When you sell shares of stock of a corporation, all you need to determine your gain or loss and how to report it on a tax return are the confirmations and/or monthly statements detailing the purchase and sale. Beginning back in 2011, brokerages are now also required to issue a tax form (1099B), reporting all aspects of securities sales to the seller, as well as to the IRS, showing the basis of the securities sold and the net proceeds of the sale. Basis is just a tax term referring to the cost of the shares, including purchase commissions. For stocks, basis is fixed upon purchase, and does not change. Net proceeds refers to the gross proceeds less the sales commission. If the 1099B is correct, the shareholder doesn't even need the original documents from the brokerage showing the purchase and sale transaction details. For units of a partnership, however, the purchase cost is just the starting point for determining basis. It changes from that point depending upon the income, expenses, increases/decreases in partnership debt, and distributions received, for each year the partnership interest is owned. Thus, to correctly determine basis for a PTP, all annual K-1s relating to the partnership interest ever received must be retained.
The "free lunch" whereby the partnership distributions are not taxed is not as free as might have been assumed originally, as is the case with most "free lunches". As noted above, the basis is affected going forward by several variables, but the most impactful by far is usually the distributions received, which reduce basis dollar for dollar. Thus, for a partnership interest held for a long time, basis can be reduced substantially. In fact, it could even be reduced to zero, and if that occurs, the excess of distributions over basis will be required to be reported as income. The income in this case will be treated as capital gains income, presumably long term. When the units are sold, the "free lunch" on distributions is taken back to a certain extent, as the gain on the sale is usually increased substantially by the reduction in basis. True, some of the gain on the sale will benefit from the lower rates on long-term capital gains, assuming the position had been held longer than one year, and the gain is substantial, but even this is not as good as it first sounds. The reason is that a substantial portion of the gain is considered to be "recaptured depreciation" on the sale of depreciable "business property" that was considered to have been sold when the partnership interest was sold, and this portion must be reported separately on the tax return (Form 4797), and will be taxed as ordinary income. The partnership will report this figure to the partner on a "sales schedule", which will be included in the year-end package sent to the partner, if any units have been sold, along with the K-1. Only the gain in excess of the ordinary gain thus reported, if any, will benefit from the favorable capital gains treatment, and only then if the interest in the partnership had been held longer than one year.
Still, under the taxation concept that deferring payment of taxes is preferable to paying immediately, and also in recognition of the fact that at least some of the gain upon sale may be treated favorably as long-term capital gain, there is at least some validity to the argument that MLP investors receive favorable tax treatment over stock investors. The question is, at what cost, in terms of complexity? This article will provide some insight into that question. The next section will examine the K-1 in more detail.
Current Year Reporting - Form K-1
As noted, each limited partner will receive an annual accounting of their ownership interest in the partnership on a Form K-1. These forms are not available until late in the tax filing season, which is another drawback of MLPs. They typically start to arrive in the mailbox (or become available online) around the middle of March. Frequently, the receipt of a K-1 is when the novice investor realizes for the first time that what is owned is not a "normal" stock, but rather a partnership interest. The K-1 is subdivided into three parts. Part I, Information about the Partnership, is self-explanatory, with basic identifying data about the partnership. Part II, Information about the Partner, is somewhat more involved, indicating the partner's share of ownership, and some details regarding changes in the partner's holding during the year. A subset of Part II is item L, Partner's Capital Account Analysis, which corresponds somewhat to basis, but not completely. I will defer further discussion of Part II to the next section, which will focus on Part II and Basis. Before moving on to Part III, however, note that if Part II indicates that the partnership is considered by the IRS to be a tax shelter, a Tax Shelter Registration Number will be indicated, and IRS form 8271, Investor Reporting of Tax Shelter Registration Number must be filed with the tax return if the result of the K-1 processing results in income or any type of deduction on the tax return. It is rare for a PTP to be a registered IRS tax shelter, but not impossible.
Part III, Partner's Share of Current Year Income, Deductions, Credits, and Other Items, presents data that may need to be reported on the tax return. Before reviewing the individual items, it is important to understand some concepts. PTPs are subject to a hybrid set of partnership rules that are different from the rules for partnerships that aren't PTPs. First, the individual items in Part III are considered as to whether they would be classified as passive or non-passive, if the K-1 were from a non-PTP partnership. Identified non-passive items are reported directly on the tax return. Passive items are summed, and whether or not these items are reported on the tax return and where depends upon whether the accumulation(s) are positive or not, which K-1 boxes the numbers originated from, and whether or not at year-end the taxpayer still owned an interest in the partnership. If the interest in the partnership had not been completely disposed of during the year, any net passive losses on a given PTP are suspended, and are not used until the partnership realizes a passive gain in a future year, at which time the suspended losses can be used to offset the gain. If the holding is disposed of in a total disposition of the interest, any outstanding suspended passive losses can be taken in that tax year. Note that a partial sale does not "free up" the suspended losses; only a total disposition allows the losses to finally be used. Now, in case any reader has learned of the existence of Form 8582 and read about passive gains and losses from different passive activities being combined, be advised that these rules do not apply to PTPs. Suspended losses from a specific PTP can only be used to offset passive gains from that same PTP, or when the interest in that specific PTP is completely disposed of. They cannot be combined with gains/losses from other PTPs, nor from other non-PTP passive activities, such as rental property activities or non-publicly traded partnership activities.
The passive items will be summed into two accumulations, one for Schedule E items, and one for Form 4797 items. The accumulations will initially begin with any corresponding suspended losses from prior years. After all current activities are added in, the results are either reported on Schedule E Part II, Form 4797 Part I, or held as suspended losses, with the specifics determined by the values as accumulated, and whether or not the entire interest in the partnership was disposed of during the year. The mechanics of reporting the results of these two summations on the current return, if required, and if so, where to report them, or whether instead to not report them currently, but rather carry them over as suspended losses, are complex, and will be summarized shortly.
Part III items represent the partner's share of current year activity. A detailed review would extend for many pages, and most readers would get lost in the swamp, so that will not be attempted here. For this article, some basics are enough to allow for a conceptual understanding. Each box defines a category of income or loss, expense, or other activity. Some boxes can contain multiple items, and may refer to a statement provided to the partner, in lieu of a single value. Some categories are reportable immediately on the tax return. Some are accumulated into the two major passive income/loss categories defined above, and are either reported immediately, or suspended until, per the rules, they can be used. Most items add to or subtract from basis and the amount at risk. Some items require that additional tax forms be prepared for proper reporting. Some items require a partner-level decision on how to report the item. Generally, boxes 1, 2, and 3 define passive gains or losses reported on Schedule E Part II or suspended, boxes 5 through 9 report portfolio income items to be reported immediately, box 10 defines passive gain/loss reported on Form 4797 or suspended, boxes 11 through 18 and 20 define a myriad of special activity categories with specialized handling requirements, and box 19 reports distributions received by the partner.
The non-passive items are reported directly on the tax return. This will include all portfolio income items in boxes 5 through 9c, plus potentially data from boxes 11 through 18 and 20, some of which will require additional tax forms. The disposition of the two passive accumulations, which mostly come from boxes 1 through 3 and 10, depends upon whether or not a total disposition of the partner's interest has occurred, and the accumulation results. Note there are two totals, one for Schedule E, and one for Form 4797, which include the respective suspended loss totals from prior years, plus the current year values added in.
If a total disposition occurred: The Schedule E accumulation is reported on Schedule E, Part II, Column (h) if it is negative. Column (h) is for reporting a nonpassive loss. The loss is shown as a positive number. If the Schedule E accumulation is positive, it is reported on Schedule E, Part II, Column (j), as nonpassive income. The Form 4797 accumulation is reported on Form 4797 Part I, as accumulated. A loss will show as a negative number, while a gain will show as positive.
If a total disposition did not occur: If both accumulations are positive, they are reported on Schedule E, Part II, Column (j) as nonpassive income in the case of the Schedule E accumulation, and on Form 4797, Part I in the case of the Form 4797 accumulation.
If both accumulations are negative, nothing is reported on the tax return. The losses will be suspended, maintained as two separate totals, to be combined next year with new accumulations, after which the same tests for reporting will be applied.
If the two passive accumulations are not both positive nor both negative, and when combined, result in a positive value, no losses are suspended. If the Schedule E accumulation is positive, the positive excess is reported on Schedule E, Part II, Column (j), as nonpassive income, the portion of the Schedule E accumulation matching the negative Form 4797 accumulation is reported on Schedule E, Part II, Column (g) as passive income, and the Form 4797 accumulation is reported on Form 4797 Part I as a negative number.
If the two passive accumulations are not both positive nor both negative, and when combined, result in a positive value, no losses are suspended. If the Schedule E accumulation is negative, it is reported on Schedule E, Part II, Column (f), as a passive loss, and the Form 4797 accumulation is reported on Form 4797 Part I, and it will be a positive number.
If the two passive accumulations are not both positive nor both negative, and when combined, result in a negative value, the excess loss is suspended. If the Schedule E accumulation is negative, the amount equivalent to the Form 4797 positive value is reported on Schedule E, Part II, Column (f), as a passive loss, the remainder is suspended as a Schedule E suspended loss, and the Form 4797 accumulation is reported on Form 4797, Part I, and it will be a positive number.
If the two passive accumulations are not both positive nor both negative, and when combined, result in a negative value, the excess loss is suspended. If the Schedule E accumulation is positive, it is reported on Schedule E, Part II, Column (g), as passive income, the corresponding portion of the Form 4797 loss is reported on Form 4797 Part I as a negative number, and the remainder of the Form 4797 accumulation is suspended, as a Form 4797 suspended loss.
Note that if the net passive income from a PTP is positive, it is included in modified AGI when figuring the allowable loss from rental real estate activities with active participation. It should also be included in the calculation of modified AGI on line 7 of Form 8582. These considerations would only apply if the individual had rental real estate and/or non-PTP partnership interests, in addition to the PTP interest.
Further, positive net passive income from a PTP is also treated as investment income for purposes of the deduction for investment interest expense on Form 4952, and also for the new Medicare Net Investment Income (NII) tax, as figured on Form 8960.
Basis, At-Risk, and Capital Account - Form K-1 Part II
As noted, basis and the amount at risk are both affected by the ongoing activities of the partnership, as detailed in Part III of the K-1. Of course, the initial values for these items begin with the acquisition cost of the partnership units, which includes the brokerage commission(s). An item often overlooked that affects basis and possibly at risk is a net change in the partner's share of partnership liabilities from one year to the next, as indicated in Part II, Item K, of the K-1. If the current K-1 shows values here that differ from the prior year K-1, a basis adjustment is required, and the at risk amount may also be affected. These liabilities fall into three categories: recourse liabilities, qualified nonrecourse financing liabilities, and nonrecourse liabilities, as shown on the K-1. Basis is increased accordingly if any of these liabilities increased from the prior year, and decreased accordingly if any of them decreased from the prior year. Note that basis limits any losses that could otherwise be taken, in that if basis goes to zero, losses or deductions in excess of basis cannot be taken. They can, however, be suspended, and taken in a later year to the extent basis increases above zero. Similar to basis, the amount at risk limits losses that could otherwise be claimed. For a limited partner of a PTP, basis and at-risk are nearly synonymous. About the only way basis can deviate from at-risk is if the partner's share of nonrecourse liabilities changed from one year to the next. In this situation, basis would be affected, but at-risk would not. The basis and at-risk limitations on taking partnership losses will only come into play for holdings that have been held for some time, as basis and at-risk approach zero. To summarize, basis and at-risk both begin with purchase cost, are both subject to adjustment if the partner's share of partnership liabilities changes from one year to the next, and are both affected by distributions received and gains, losses, and expenses that have occurred since purchase. Further, any losses that could be taken, per the passive loss rules, are also limited to the basis of the partner's interest, and also by the amount the partner has at risk in the holding. In terms of sequencing, the partner's basis and at-risk limitations for a new tax year are determined first, starting with prior year basis and amount at-risk, then increased by any purchase costs incurred during the year, then adjusted per current year changes due to changes in liabilities, then increased by positive income and any other additions from current year activities, then reduced by any current year distributions, and then finally reduced further by current year losses and expenses.
What about the partner's capital account, as detailed in Part II, Item L? If prior year K-1s and purchase details are not available, it may be the only source for basis, but that doesn't mean it is correct. To quote from the IRS Partner's Instructions for Form K-1:
"The partnership is not responsible for keeping the information needed to figure the basis of your partnership interest. Although the partnership does provide an analysis of the changes to your capital account in item L of Schedule K-1, that information is based on the partnership's books and records and cannot be used to figure your basis. You can figure the adjusted basis of your partnership interest by adding items that increase your basis and then subtracting items that decrease your basis."
The instructions then present a worksheet for determining basis, as discussed in the preceding sections.
Reporting a Total Disposition of an Interest in the Partnership
Whenever any units of a PTP are sold, the partnership will include a sales schedule with instructions for reporting the sale. The sales proceeds must be determined independently by the partner, using brokerage statements or confirmations. The proceeds will be the net amount after deducting sales commissions. The original purchase amount will likewise need to be determined independently by the partner, and will be the initial purchase cost of the units, including purchase commissions. The partnership sales schedule will supply the cumulative adjustments to basis, which will include all cumulative K-1 Part III activity, including distributions. This value, which will almost always be negative, is subtracted from the original purchase cost to derive the adjusted basis. However, if all K-1s are available and the correct adjusted basis can be rigorously determined, the partner should use that adjusted basis in lieu of the adjusted basis determined using the adjustments to basis supplied by the partnership. Either way, the sales proceeds less the adjusted basis yields the initial gain or loss on the sale. This gain is composed of two parts, an ordinary gain component, which represents recapture of depreciation on business property considered to have been sold, and a capital gain component, which is any remaining gain in excess of the ordinary gain. The partnership-supplied sales schedule will provide the value to use for ordinary gain. This is reported on Form 4797, Part II, Line 10. The remainder is reported on Form 8949, either short-term or long-term, depending upon how long the units were held, with the sales proceeds shown as determined, and the basis as the adjusted basis less the amount reported as ordinary gain on Form 4797. If the brokerage reports basis, that value is shown in the basis column, and an adjustment to basis is made to force the result to the correct capital gain. The abbreviation "EDPA", which stands for "Entire Disposition of Partnership Activity", should be used on Schedule E, Form 4797, and Form 8949 in the description column, along with the partnership identification, such as the symbol.
If the total position was partially short-term and partially long-term, determine the percentage applicable to each holding time, and pro-rate all values accordingly. A partnership holding is considered to have one unified basis, and all basis adjustments are applied pro-rata. The costs of the individual blocks of units are disregarded, as far as weighting is concerned.
If the initial gain is negative, or is positive, but less than the ordinary gain supplied by the partnership, the ordinary gain is still reported as a positive value on Form 4797, Part II, Line 10. This ordinary gain is then subtracted from the initial gain, which is the sales proceeds less the adjusted basis, and in this case it will be negative, indicating a loss. The loss is then reported as a capital loss on Form 8949 and Schedule D.
Reporting a Partial Disposition of an Interest in the Partnership
In this case, the units sold are not treated like a block of stock would be handled, either first-in, first-out, or by identified block. The IRS, per Revenue Ruling 84-53, considers that a partner has a unified basis in the total partnership interest, and that a partial sale of the total interest represents a partial sale of each portion of the interest acquired in separate transactions up to that point. As noted, a partial sale has no effect on suspended passive losses - they remain suspended. To determine the adjusted basis of the sold units, the total original basis from all purchases would be pro-rated, per the percentage of the total holding sold, to get the original purchase basis of the sold units. Then, the cumulative adjustments to basis value supplied by the partnership would be used to determine the adjusted basis of the sold units. From that point, the sales proceeds and the ordinary gain as reported by the partnership would be used as described preceding. Since the adjusted basis of the sold units was determined and used to calculate the gain or loss, the remaining basis going forward would begin with the total basis as rigorously calculated, including the year the units were sold, and then would be reduced by the adjusted basis of the sold units.
Since even a limited partner is considered to be engaged in the economic activity of a partnership, a sizeable holding in one or more partnerships doing business in a given state can cause an investor to incur a state income tax reporting obligation for that state. Further, gains from the sale of partnership interests may be required to be reported to the states where the partnership has operations. Some states have different rules for depreciation than the Federal rules, and are termed "non-conforming" states. In short, there are a myriad of state tax complication possibilities. The best resource for determining the requirements for state reporting is the partnership instructions for the partner, and if available, a help line provided by the partnership for partners with tax questions.
A decision to invest in a PTP should not be made casually, without an understanding of the income tax implications. The potential returns need to be weighed against the tax complications and associated costs of compliance.
Disclosure: The author is long BBEP, WPZ, OKS, APU, MEMP, CMLP, NS, RIGP, LINE, LGCY.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have been employed as an income tax preparer for a national employer since 2013. While I have taken advantage of the educational resources available to me as an employee of the firm, the article as written is my own interpretation of tax law, and has not received any peer review nor any other type of confirmation from my employer. I am currently studying for the IRS SEE (Special Enrollment Exam).