MLPs And K-1s, And UBTI, Oh My!

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Includes: AB, APLP, CEQP, CPLP, CVRR, MLP, STON, WLKP
by: Darren McCammon

Summary

MLPs can provide a good source of tax advantaged income.

Many investors worry, however, about the tax issues and hassles associated with them.

I relate my experiences in owning dozens of MLPs over the years in hopes of separating reality from fiction.

In almost every article regarding a Master Limited Partnership (MLP), one comes across a comment worrying about the tax reporting consequences and hassles of their ownership. Since it is the time of year where I have a bunch of my K-1s handy, I thought I would provide some actual facts and experience to help potential future investors better decide whether owning an MLP is worth the hassle for them.

I have owned literally dozens of MLPs both inside and outside of IRAs over the years; so obviously, I don't consider them a big deal. Maybe that is a bias, but it is also experience. Experience which others might find informative.

First, I should probably point out that not all MLPs even issue K-1s, Capital Product Partners (NASDAQ:CPLP) for instance instead issues a normal 1099, just like all the other C-corps out there. I think they get away with this because they are a special category of MLP called a Marshall Islands MLP, but it doesn't really matter why. Somehow certain companies like Capital Product Partners were able to finagle it that investors get both the benefit of receiving tax deferred income and don't have to deal with a K-1. The rest of this article will deal with the more typical MLP, the one's reporting via a dreaded K-1.

Benefits

The reason most investors consider owning an MLP is pretty straight forward, tax advantaged income. MLPs are partnerships, they therefore pass-through income to the partners (you the investor) thereby not having to pay tax on it themselves. Entities which qualify for pass-through status - MLPs, REITs, BDCs, mREITs, etc. - in this way avoid double taxation. Most companies, C-corps, have to pay taxes on income, and you in addition have to pay taxes on the dividends issued by them, double taxation. The government is in effect taxing the same money twice. Pass-through securities don't have this issue so they tend to have more money available to issue to you the investor.

Since many of these pass-through securities, including MLPs, own assets which produce significant depreciation (ships, real estate, etc.), the actual income partners recognize also tends to be minimal. This is somewhat similar to a person who owns a business vs. the employees who get paychecks from that business. The business owner, or partner in your case, gets to take advantage of more write-offs. The economics of MLPs even allow them to hire high priced tax professionals to make sure their investors get the maximum tax benefit possible. Don't confuse the minimal income these partnerships typically show on K-1s with the actual distribution payouts being minimal, however. Frequently, MLP distributions result in yields in the double digits. This is because what is paid out by an MLP has everything to do with actual cash flow, Cash Available for Distribution, CAD, and almost nothing to do with income (an accounting fiction high priced professionals are pretty good at thwarting). CAD and taxable income are two very different things.

As an actual example, 1,000 shares of Archrock Partners (NASDAQ:APLP) issued $1,140 in distributions last year; however, the taxable business income was $0. Yes, that is not a typo, no tax was due on $1,140 in distributions. As a matter of fact, you could have had $1,140,000 in distributions from APLP and still had no current year taxable income. Distributions actually paid and taxable income also do not necessarily have much to do with each other.

There is of course a catch. The distribution paid does lower your tax basis. So, if you paid $10,100 for 1,000 shares of APLP stock at the beginning of the year and got $1,140 in distributions from it, your tax basis is no longer $10,100. It's $9,020 instead ($10,100 paid - $1,140 distribution = $9,020 tax basis). This means when you eventually sell APLP, you are going to owe capital gains taxes (15-20%) on that $1,140 you got distributed to you previously. That is if there is a gain, and if that gain is not tax protected by being in an IRA, and if you did not die and leave the shares to your kids in the meantime. (Inherited shares get a step up in basis, one of the few ways I know of to never pay the tax man).

So, in most cases, that $1,140 is not tax free, it's just deferred until you sell. But that is still a meaningful benefit. I'd rather pay taxes $171 (15% capital gains tax rate) on my $1,140 in distribution 10 years from now when I sell, than $319 (28% marginal tax rate) on that distribution today.

For this reason, the tax deferral benefit, many people say MLPs are best held in taxable accounts. IRAs already defer taxes until you take the money out, so the MLP deferral feature is essentially wasted wrapped up in an IRA. With this I agree.

However, that does not mean you can't hold an MLP in an IRA, or that it's a problem. Most MLPs still provide lots of income because they avoid double taxation; that benefit occurs regardless of what type of account you hold it in and can outweigh other considerations. Don't let the tail (tax considerations), wag the dog (total return).

UBTI

But what about Unrelated Business Taxable Income (UBTI)? Is that a problem in an IRA?

Well yes, but only if you own a fair number of shares. You don't have to report UBTI income unless it exceeds $1,000 in a single account in a single year. If it does, your broker is supposed to give you a special 990-T form; but I don't know if they will as I have never actually exceeded the $1,000 single account limit.

In a typical year, UBTI is usually pretty small in most MLPs (exceptions are when large transactions take place). So, it usually takes a fair number of shares to trip the $1,000 UBTI limit. More shares than many individual investors tend to own in a single account. I tend to try to keep my total ownership in MLPs in any one account under $50k to help avoid UBTI. For example, pulling some K-1 forms I have handy, here's approximately how many shares they imply one would have had to own in order to produce $1,000 in UBTI (UBTI can typically be found in box 20 on your K-1 under code V):

  • AllianceBernstein (NYSE:AB) - 2,200 shares, $49k
  • Archrock Partners - Unlimited, APLP had no UBTI reported in 2016
  • Crestwood Equity Partners (NYSE:CEQP)** - Significant transaction occurred, UBTI limit likely tripped for many investors
  • CVR Refining (NYSE:CVRR)* - 12,000 shares, $110k
  • StoneMor (NYSE:STON)* - 6,400 shares, $59k
  • Westlake Chemical (NYSE:WLKP) - unlimited, WKLP had no UBTI reported in 2016

* CVRR and STON had negative UBTI in 2016 so you would actually be getting a credit of $1,000 on your taxes

** CEQP may have tripped the $1,000 limit for many people. They had a significant transaction announced in April which closed in June. I sold in April (at $18 for an approximate 80% gain) in part to avoid the potential UBTI. Thus, I don't know the limit where UBTI would have been tripped. Those who held probably are not complaining too much however, even if they do have to pay UBTI, as the units are currently at $25 (approximate 200%+ gain). High UBTI can mean high profits and returns. So being in a situation where you have to pay UBTI is not necessarily a bad thing.

In the last decade of owning dozens of MLPs in multiple IRA accounts, I have never once had to report UBTI. I do, however, typically keep my MLP ownership in any one IRA account under $50k in order to avoid the possibility and did (unfortunately) sell CEQP in order to avoid potential UBTI.

Tax Reporting Hassles and Cost

I use Turbo Tax do report my taxes each year. Because I own my own business and have numerous investments, preparing taxes is a very time consuming unwelcome chore for me. However, K-1 reporting is not a significant contributor to that hassle.

The K-1s I receive for holdings in my IRA I typically file. It's a round file on the floor next to my desk that Waste Management conveniently picks up each week. Not much hassle there. Should I exceed the $1,000 UBTI limit in a single IRA account (unlikely), and my broker fails to send me the appropriate 990-T form (not really sure how likely since it's never happened), and I get audited (has also never happened), and the auditor notices the lack of a necessary 990-T form reporting UBTI (hard to notice what is not there, but I guess that's what they get paid for), if all those happen together, I guess I will just have to pay the fine.

I worry more about winning the lottery.

The K-1s I receive for my regular taxable account on the other hand, I do have to report. That takes me about 10 minutes per K-1 in Turbo Tax, but it might take double that the first few times you do it. Not a lot of hassle considering the $1,000+ tax advantaged income stream typically generated by each one of these MLPs for me each year.

If someone prepares your taxes for you, you WILL have to pay extra because you have K-1s. This site estimates $145 in average cost for return preparation in 2017, and $225 for those with investments including K-1s. An extra $80 on average. Wells Tarkington actually details out specific tax preparation fee's saying they charge an extra $25 per K-1 (wow, full disclosure of tax preparation fee's, impressive transparency). So, if I ever have Wells Tarkington do my taxes for me, the three MLPs I have in my taxable account are going to cost me an extra $75.

As an interesting thought experiment, your typical MLP currently pays about 6% more in distribution than the S&P 500.

That is not really fair, however, since your typical MLP might pay 90% of income out in distributions, whereas the S&P 500 pays out closer to 40%. If we adjust that such that each was paying out 100% of income as distributions, your typical MLP yield would become about 8.8%, whereas the S&P 500 would yield about 4.8%. So instead of a 6% difference, its only 4%. Let's use 4%. At a 4% difference, this implies, all else being equal, you need to invest at least $625 per MLP to have the extra yield cover the cost of tax preparation (4% * $625 = $25). For most people, this does not seem a significant hurdle.

There is something about K-1 reporting that is a real hassle however. While I have received most of K-1s already (3/24), I also typically get revisions, many of which don't arrive until a week or two before taxes are due. This is a hassle for anyone who wants to prepare their taxes early. In my case, it's a good excuse for why I put tax preparation off to the last minute.

Conclusion

There are additional hassles and reporting costs associated with owning Master Limited Partnerships. Each person must decide for themselves if the benefits outweigh the costs. Hopefully, having some real-life data and examples helps to dispel some of the fear so each of us can make a better, more rational decision.

Disclosure: I am/we are long CPLP, APLP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Darren is not a tax expert and is not giving tax advice. He also does not know who you are much less your particular situation; so how can he recommend this equity or for that matter any investment to you? Don't follow a person who may be crazy, do your own due diligence.