The Unique Tax Benefits and Consequences
Investors and taxpayers have a variety of investment options from which to choose. An important factor to consider is that the tax treatment of these can differ greatly. One popular option is investing in Master Limited Partnerships (MLPs), also known as publicly traded partnerships (PTPs) among tax professionals. PTPs are unique because you are not only purchasing stock, you are also purchasing a limited partnership interest in a publicly traded partnership. Along with a unique investment structure, there are also unique tax benefits and consequences.
Here are some of the basics of a partnership structure. A partnership is an entity that is owned by a group of investors, called partners. The partnership structure is such that the entity does not pay income tax on its net earnings; rather, the earnings are passed down to the partners, based on their respective ownership percentages. The partner then reports their share of the earnings on their tax return. The partnership will, from time to time, distribute cash to the partners, typically for use in covering the additional tax liability incurred by the partner’s investment in the partnership. Distributions may be made at the partnership’s discretion.
When you invest in a PTP, as a partner you will receive periodic cash distributions. Generally, these distributions are tax-free, to the extent you have basis. Your initial basis is the amount you pay for the underlying shares of stock. Each year, you will receive a Schedule K-1, which reports your share of the partnership’s net earnings or losses. You will need to report the information from the Schedule K-1 on your tax return. Earnings will increase your basis, and losses will decrease your basis. In addition, cash distributions will decrease your basis. Once your basis falls below zero, your distributions will be taxable, subject to long-term capital gain rates. The inclusion of the distribution into income will restore your basis back to zero.
If the PTP reports losses, you generally cannot take these losses against your other income during the year. The exception is if you sell the PTP shares in the same year. Instead, these losses are suspended and carried to future years. These losses can be used to offset, or absorb, net earnings you report for the PTP. Any accumulated losses that are available in the year you sell the PTP will be released and used to reduce your income.
This leads to the next aspect of owning PTPs – what happens when you sell it? First, you will see the sale reported on Form 1099-B of your brokerage account. The proceeds and original cost basis are reported to the IRS, along with the realized gain or loss. You must report the sale from the Form 1099-B. Then, you must refer to the Sales Schedule that is accompanied by your Schedule K-1. This schedule will provide you with basis adjustments and the ordinary gain that you must recognize on the sale of the PTP. Your basis adjustments reduce your original cost basis, thereby increasing your gain or decreasing your loss. From the calculated gain, you must back out the ordinary gain provided on the sales schedule. Your ordinary gain is taxed at your normal income rate. The difference from the total gain less than ordinary gain will be your capital gain. This often catches taxpayers by surprise, particularly those who are new to investing in PTPs.
As you can see, investing in PTPs creates many tax issues and complications. If you find yourself investing in PTPs, please contact your Maddox Thomson tax advisor to ensure the proper reporting of these complex investments.