Last week, I wrote about end-of-year tax saving tips, which included owning master limited partnerships (MLPs). MLPs are good to own because of their tax-deferred distributions (MLPs pay distributions, not dividends).

That sparked a question from reader Lee M., who asked whether MLPs are really worth the effort, considering the more complicated tax implications, which I’ll get into in a minute.

That’s an excellent question because MLPs often have strong yields ranging from 5% to double digits.

The average historical yield for MLPs is 7%. Some of the current top-yielding ones are…

• Icahn Enterprises (Nasdaq: IEP), with a 15.9% yield
• MPLX (NYSE: MPLX), with a 12.5% yield
• Natural Resource Partners (NYSE: NRP), with a 12.1% yield.

But there are some things you should know before chasing those attractive yields…

MLPs are partnerships that are often, though not always, in the oil and gas pipeline business. When you buy an MLP, you are considered a partner, not a shareholder. As a result, you own units, not shares, and you are paid distributions instead of dividends.

These aren’t just semantics. There are important differences to consider as an investor in an MLP versus an investor in a regular company (C-corporation).

The most important difference revolves around how the distribution is treated from a tax perspective.

When you own a regular stock and are paid a dividend, if the stock is held in your taxable account, the dividend is taxed at 15% for most investors. The highest earners pay 23.8%.

Because you are a partner in an MLP’s business, its distributions are considered a return of capital. As a result, the distribution is not considered a taxable dividend. Instead, it lowers your cost basis.

Here’s how it works…

Let’s say you buy 100 units of an MLP for $20 per unit, costing $2,000. Each year, you receive $1 per unit in distributions that are all return of capital. So you receive $100 in income.

If this were a normal stock, you’d pay at least 15%, or $15, in taxes on that income.

But because it’s an MLP and the distribution is a return of capital, you pay zero tax on the distribution. Instead, your cost basis is lowered by the amount of the distribution – in this case $1. So your new cost basis is $19.

If you were to sell the units at $25, you’d have a $6 capital gain instead of a $5 one and you would pay capital gains taxes on the $600 in profit rather than $500.

Uncle Sam will get his money somehow. But in the case of MLPs, he has to wait until you sell.

An investor who bought a $20 per unit MLP that paid $1 per year in distributions could collect tax-deferred income for 20 years.

So what happens once your cost basis falls all the way to zero? At that point, the distribution that you collect each year is taxed as a capital gain in the year it is received.

Capital gains currently have the same tax rate as dividends. That could change, but it will likely take many years of tax-deferred income before that happens.

MLPs can also be used as an estate planning tool.

Under current law, an heir who inherits an MLP can step up their cost basis. So let’s say your parent bought the MLP at $20 15 years ago and collected tax-deferred income for 15 years. Their cost basis is now $5.

At that point, they pass on and you inherit the investment. But now the price is $40. Your new cost basis is reset at $40, and future distributions lower the cost basis from that new $40 level.

President-elect Biden’s proposed tax policy eliminates the step-up basis so that if you inherited the MLP, your cost basis would be $5, and if you sold at $40, you’d owe tax on $35 in capital gains.

Of course, this is still a proposal and not yet a piece of legislation. Even if it passes the House of Representatives, it still has to get through the Senate, which is not a slam dunk – especially if Republicans hold on to their majority.

Lastly, as a partner in the business, you receive a K-1 tax statement each year instead of a 1099-DIV like you would for a dividend stock.

These K-1s are more complicated and are often amended throughout the year. As a result, your tax professional may charge more for handling K-1s.

So in the end, are MLPs really worth it?

I believe they are. When you can enjoy an average 7% tax-deferred yield plus potential upside in the beaten-up energy sector, it’s worth a little extra paperwork.

Good investing,

Marc