Tax and Financial Planning Considerations With Master Limited Partnerships

Publicly traded master limited partnerships (MLPs) have long been an option for investors seeking ways to enhance yield while minimizing their tax burden. 

However, due to recent and significant fluctuation of oil and gas prices, there is greater risk associated with MLPs then there has been in the past. Along with this volatility of their MLP holdings, some MLP investors may now also be in for an unpleasant tax bill as well. 

Master Limited Partnership Overview

A publicly traded oil & gas MLP is an asset that meets specific standards with regards to the source of its income and certain distribution requirements. Since an MLP is a partnership for tax purposes, an investor is considered a partner and receives partnership units rather than stock. This structure permits the MLPs to avoid taxation as tax attributes flow directly to each partner (investor). Other forms of publicly traded securities are typically structured as corporations, which carry with them the burden of double-taxation. 

MLPs can be attractive to investors since they often provide high distributions on a frequent basis. MLPs are appealing from a tax standpoint because these distributions are typically a return of capital and avoid taxation. However, this return of capital also has the effect of reducing the investor’s basis, which plays a critical factor in determining gain or loss upon ultimate disposition of the investment. One of the reasons MLPs offer distributions without immediate tax consequence is because positive cash flow from operations, which would otherwise be taxable income, is often offset by depreciation and drilling deductions. Additionally, the MLP could sell the drilling well or pipeline, potentially resulting in long-term gain. As a result, investors enjoy initial tax-free return of capital rather than recognizing ordinary income while later recognizing gains at the more favorable capital-gain tax rate.

Current Issues

From both a tax and financial perspective the MLP appeal is evident when oil & gas prices have risen. However, due to uncertainty in the energy sector, some MLPs may now pose troubling tax consequences that investors may not have anticipated. Many energy sector MLPs have structures that contain significant debt in order for them to meet their capital needs. This structure supports high output and cash distributions to remain competitive within the industry. With recent declines in oil prices through 2015 and into early 2016, some MLPs have had trouble paying off maturing debt or interest payments.  As a result, some MLPs have refinanced this debt or have sold underlying assets to make payments.

Debt refinancing by the MLP that results in debt forgiveness creates cancellation of debt income. Additionally, any sales of business assets may be considered section 1231 assets and yield either current capital gains or potentially suspended ordinary losses. As MLP investors are partners in these investments, unfavorable tax attributes, like ordinary income or gain, flow through regardless of whether any actual distributions occurred. The very benefit of MLPs being structured as partnerships may now leave some investors with an unexpected tax bill. Mutual fund investors experienced a similar situation fifteen years ago when the dot-com bubble burst and the funds sold off assets. Subsequent distributions of capital gains from these sales created a tax burden for investors - even though their holdings decreased in value.

Future Issues

Given the current market issues with MLPs, investors may feel compelled to sell off their interests.  However, this option should be considered carefully before pursuing. Remember all of the depreciation and drilling deductions that offset the MLP’s income thus allowing tax-free distributions?  IRS requires that these benefits be recaptured as ordinary income upon sale of MLP units. In a simplistic example, if an MLP holder bought units at $10 and received $2 of distributions as return of capital because of depreciation deductions, basis is lowered to $8. If the MLP is sold at $5, only $3 would be capital loss ($8-$5) and $2 of depreciation could be recaptured as ordinary income. Far from an ideal scenario is to take a loss and still have ordinary income tax to pay on the transaction. This example is a stark reminder that MLPs should be viewed as a tax deferral investment, rather than avoiding ordinary income altogether.

All hope is not lost however. If an MLP had generated passive tax losses over time, it is likely that those losses have been suspended. Upon the entire disposition of the MLP interest, these ordinary losses can be released for tax purposes to offset other income, including any ordinary income recapture. It is important that these tax ramifications be considered along with the financial implications when looking to dispose of MPL interests. 

The once clear benefits of being a partner in an MLP may now prove to be detriments for many investors come tax time. Solvent MLPs that rely less on debt in their capital structure are less likely to produce debt forgiveness income or unanticipated capital gains passing to partners, while less financially secure MLPs can produce these negative tax consequences. As a result, navigating the intertwined tax and investment considerations of MLPs for an individual investor can be a complicated endeavor and a proper analysis of an investor’s MLP holdings may be worthwhile.