Ownership schedule: Your history of purchases and sales, and the dates and quantities of each, are listed here.
Sales schedule: If you had a taxable sale during the year, this schedule is used primarily to provide information regarding your ordinary gain (recapture). This schedule will be provided if you sold units during the year.
State schedule: This schedule lists all the states in which the MLP operates and the limited partner’s share of income/(loss) attributed to such state. You may be required to file tax returns in these states. Your tax adviser should be able to assist you in understanding any state
Additional details for the boxes on the schedule K-1 and where such information generally feeds into your tax returns are outlined as follows:
Additional tax complexities: UBTI, passive activity and estate planning
Employee benefit plans, tax-exempt organizations (foundations, charitable remainder trusts, corporate pension plans) and certain tax-advantaged retirement accounts (including 401(k)s and individual retirement accounts) are normally, by definition, very tax efficient.
They also have special tax rules regarding unrelated business taxable income (UBTI), which is almost always generated by investing in MLPs. In simple terms, an “unrelated” trade or business is defined by the IRS to not be substantially related to an account’s or organization’s charitable, educational or other purpose. An investment in an energy-related MLP can be classified by many tax-exempt investors as “unrelated” to their day-to-day mission.
Most income allocated to MLP limited partners is characterized as UBTI and may be subject to taxation if UBTI from all investment sources exceeds $1,000. Essentially, in such a circumstance, your tax-exempt account could become subject to taxation. Furthermore, gains upon sale could be subject to tax if the investor finances the MLP investment using debt or the MLP itself has debt.
It is also important to note that income from MLPs is considered UBTI for charitable remainder trusts. Even $1 of UBTI can be fatal to the exempt status of a charitable remainder trust.
MLP passive activity rules require active tracking
An MLP investment by an individual, estate, trust, personal service corporation or closely-held corporation is deemed to be “passive activity” by the IRS. “Passive” investments result in certain unique tax ramifications that increase complexity.
This means that an investor cannot aggregate taxable income from one MLP with a taxable loss from another MLP. In essence, a “loss” you received from “MLP A” is suspended – it cannot be applied to offset “income” in a different investment (such as “MLP B”) or other ordinary income (such as wages). You may not recognize these suspended losses until income from the same “MLP A” is allocated to you or you sell your interest in “MLP A”.
For example, assume that in a particular year “MLP A” generated a $10 loss and “MLP B” generated a $10 gain. You must report the $10 gain from “MLP B” on your current year’s tax return. You suspend the $10 loss from “MLP A” and may use it to offset income from “MLP A” in the future or upon sale of “MLP A”, but you can’t use it to offset gains from “MLP B.”
A key takeaway here is that it is important to track your passive activity, particularly the losses that you suspend.
MLPs may provide an attractive investment for estate- planning purposes
Similar to other investments, the tax basis in an MLP will reset (or be "stepped up") to the current market value when the investment is passed on to an heir upon a unitholder's death. The ”stepped-up” value will be included in the descendant’s estate and may be subject to estate tax, based on the current market value of the investment, just like other investments. However, because of the potential for tax deferral on an MLP’s distributions, the distributions received during the deceased unitholder’s life may never be taxed.
Simplify MLP tax complexities: the MLP fund alternative
For some investors, a direct ownership in MLPs may be unattractive due to, among other things, their complexity, uncertain treatments or UBTI. A properly structured MLP fund solves these issues and provides a viable investment alternative.
Tortoise recognized the investor need for such a product and formed the first listed MLP closed-end fund in 2004. This paved the way for investors to access a diversified portfolio of MLP investments with a single 1099 and no UBTI implications for tax-exempt investors (such as your IRA).
Funds that invest in MLPs can either be structured as regulated investment companies (RICs) or taxable corporations (C-corps). In the broader investment universe at the time, funds typically were structured as RICs limiting the capital invested in MLPs to 25%.
By organizing as a C-corp, a fund can invest up to 100% of its capital in MLPs, providing the opportunity for a pure-play (essentially 100%) MLP fund. While the corporation structure was not a readily apparent alternative at the time, Tortoise recognized that the nature of the underlying assets’ depreciation shield made it viable.
An MLP fund organized as a taxable c-corporation receives distributions from MLPs, and after deducting expenses, makes distributions to its stockholders. What typical funds call “dividends” or “income” are referred to as “distributions” by MLP funds, consistent with MLPs. These fund distributions are treated as qualified dividend income for federal income tax purposes to the extent of the fund’s earnings and profits, then return of capital to the extent of the tax basis, and then as capital gain. From an individual tax perspective, the tax characterization of the distributions to MLP
fund investors is based on the fund's earnings and profits, which is highly dependent on a variety of factors, including portfolio turnover and holding period of the investment.
“Return of capital” is a tax characterization of distributions, and not necessarily the traditional “return of principal” parlance. If your distribution is characterized as “return of capital” in an MLP fund, it is likely a result of the accelerated tax depreciation of the underlying MLP assets.
Any distributions that are characterized as return of capital are tax-deferred at such time and will reduce your tax basis in an MLP fund, increasing your potential gain (or decreasing your loss) upon sale of fund shares, similar to a direct MLP investment.
MLP funds structured as corporations can make the tax reporting process significantly simpler as you will receive a 1099 and not K-1s. The fund will receive K-1s and process them at the fund level. On your 1099-DIV, return of capital distributions will appear as nondividend distributions in box 3. Taxable dividend distributions will appear in box 1a and qualified dividend will appear in box 1b.
The 1099 will be sent from your brokerage house, typically by late January. Often, fund managers (such as Tortoise) will provide tax information on their websites that details the per share characterization of the fund’s distribution.
Upon sale of MLP fund shares, you will recognize capital gain or loss measured by the difference between your sale proceeds and your tax basis – there is no recapture of deprecation at ordinary rates at the investor level for an MLP fund.
In effect, an MLP fund can simplify the complexities associated with MLP investments for some investors by providing a diversified MLP portfolio, one 1099, no K-1s and no UBTI. As a corporation, an MLP fund is not subject to passive activity rules and therefore is able to aggregate income and loss from its MLP investments.
While the tax terminology may appear challenging at first, it can be worthwhile to spend some time understanding the opportunity offered by MLPs or MLP funds and whether they are a good fit for your portfolio. MLPs historically have demonstrated investment characteristics that many investors view as attractive for their portfolios