Many clients and investment advisors are partial to investing in vehicles called master limited partnerships in the investment community and known as publicly traded partnerships (PTPs) in income tax parlance. They are readily traded, like corporate stocks. But since they are taxed as partnerships, they are subject to normal partnership tax rules and some special rules all their own.
PTPs generally engage in the extraction and transportation of natural resources such as oil and gas. While these investments are not “treasure in bullion,” as the English poet John Donne said in his Meditation XVII, written in 1623, they typically have a combination of features that make them appealing to many:
- Above average dividend (called “distributions”) yield
- Lower volatility than many equity investments
- Some tax sheltering of the investment yield
The tax characteristics of PTPs range from simple to unexpectedly complex:
- there is pass-through tax treatment (no double taxation). This is where the tax sheltering of the investment yield arises. For example, a PTP producing annual cash flow of 6% might only produce taxable income of 4%, with depreciation deductions on the pipeline owned inside the PTP causing the difference. The annual taxable income is typically ordinary income ineligible for capital gain tax rates.
- Your tax basis in a PTP typically declines steadily. This is due to the deprecation pass-through. The longer you hold the PTP, the larger will be the decline in basis.
- Your gain on the sale of your PTP investment will likely be larger than you think, because of this basis decline.
- You will recognize some ordinary gain on the sale of the PTP. This is due to recapture of depreciation and other deductions that you have enjoyed while owning the investment. The longer you have owned the PTP, the larger this ordinary gain recapture will be.
- Donne asserts that “No man is an island, entire of itself.” However, for passive loss purposes on your tax return, each PTP is, in fact, an island. Tax losses from a PTP cannot be used to offset income from another PTP or from another passive investment that isn’t a PTP. The losses are suspended until the taxable disposition of your entire interest in the PTP.
- PTPs can generate unrelated business taxable income (UBTI). A tax-exempt entity (such as a retirement plan or an IRA) that generates UBTI may actually have to file a tax return and pay income tax on this income.
None of these outcomes are inherently bad if you know they are coming and plan for them. Yet many people are unpleasantly surprised by their tax outcomes when selling PTPs. If you have held your PTP a long time and assume when you sell it that a) the total taxable gain will be modest and b) the gain will all be capital gain and can therefore be offset completely by the capital loss carryforward on your tax return, you will learn to your dismay that a large tax liability “tolls for thee.”
As a result of all these rules, owning a PTP makes your tax return more expensive to prepare than owning a corporate stock, especially in the year that you sell the PTP. Here are two suggestions to help minimize this compliance cost:
1) Avoid automatic reinvestment of dividends (distributions) into PTPs.
2) Avoid making partial sales of PTP interests (such as might occur when rebalancing a portfolio).
Engaging in either of these behaviors can be “a borrowing of misery” from the tax compliance point of view. The compliance cost of these behaviors may exceed the intended investment benefits.
Check in with your Armanino advisor before selling PTP interests, especially those you’ve held a long time. Unless, of course, you agree with Donne that “tribulation is treasure” when it comes to your personal tax return!
September 06, 2017
