Master limited partnerships (MLPs) are industrial entities that are organized on a limited partnership structure but whose shares are publicly traded on the major stock exchanges. The majority of MLPs are energy companies that deal in transporting and storing oil or natural gas. An MLP must meet specific IRS specifications in order to glean the significant tax benefits of this unique business structure, and shareholders must go through some extra steps when filing annual tax returns.
According to Standard and Poor's, the current U.S. MLP market tops $100 billion, and the number of these specially-structured entities has doubled over the past seven years. MLPs operate fairly independently, financially speaking, from common stocks and bonds, making them a good choice for portfolio diversification. One of the reasons for the popularity of the MLP is that in general, it dependably produces a higher yield than common stocks due to tax regulations that require 90 percent disbursement of earnings.
Record Keeping Challenges
MLP investors must keep meticulous records of each quarterly distribution they receive during any given tax year. Each distribution affects the investor's return of capital, reducing the underlying cost base of the investment, and the investor must adjust his records accordingly. Once the ROC for a particular investment is reduced to zero, income from the MLP is taxed as a capital gain. Therefore, accurate records are essential if an investor wishes to glean the full tax advantages of an MLP investment.
Tax Reporting Challenges
Another downside of investing in an MLP is the challenge of tax reporting. While, as a partnership, an MLP does not pay corporate income taxes, investors must pay taxes on the quarterly dividends they receive. MLPs issue IRS K-1 forms to investors in place of corporate 1099-DIVs, but do not have to send them out until March 15, giving investors little time to incorporate this information in their tax returns. In contrast, 1099-DIV forms must be sent out by January 31. Additionally, larger investors may be required to report MLP distributions in the state where the MLP is located.
Many MLPs make K-1 information downloadable directly into an investor's tax preparation program, simplifying the reporting process. Those investors who still find the K-1 daunting can purchase MLP shares as exchange traded funds (ETFs), mutual funds or closed-end funds. Each of these structures carries additional costs that translate to lower yields than directly purchased MLP stocks, but tax reporting is done via the traditional form 1099, bypassing the more complicated K-1 format.
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