By Chloe Lutts
Editor of Dick Davis Investment Digest
and Dick Davis Dividend Digest
One of the Highest-Yielding Investment Types
How do I Pay Taxes on my Distributions from MLPs?
Can I Hold MLPs in my IRA?
Interest rates have been at historically low levels for years
now, which makes it easy for companies to raise money by issuing
debt (which is supposed to help the economy grow) but makes it hard
to live off the income from a portfolio of safe treasury and
investment-grade bonds-as many retirees always expected to do.
Today, investors who need a regular income stream from their
portfolio are broadening their ideas of what kind of investments
belong in an income-generating portfolio. Most have already
realized the potential of dividend-paying common stocks-the S&P
500 now yields more than a 10-year treasury bond-and many are
looking even further afield.
In the Dick Davis Dividend Digest, I help those investors by
highlighting the best income-paying investments of all kinds-with
yields from 1% to 21%.
One of the highest-yielding investment types we regularly
recommend is master limited partnerships, or MLPs.
MLPs are a unique type of business allowed under the U.S. tax
code. They're similar to a "regular" limited partnership, with a
In addition to a limited partner or partners, who provide the
MLP with capital and get a share of its cash flow in return, MLPs
also have a general partner that runs the business.
In addition, MLPs are publicly traded, by definition. The
limited partners are the public shareholders-in this case called
The primary benefit of being organized as an MLP is that the
business doesn't pay corporate taxes on its revenue. Instead the
cash flow is distributed, almost entirely, to the unitholders (who
are then responsible for taxes).
That makes MLPs a very efficient way to pass along the cash flow
of an income-generating enterprise to public shareholders. And so
they often make large regular distributions, and have very high
Not just any business can be organized as an MLP though. The tax
code requires MLPs to derive about 90% of their revenue from
natural resources, commodities or real estate. In practice, many
own energy transportation or processing facilities, like oil or gas
While they've become much more popular in these years of
rock-bottom interest rates, most investors still have a lot of
questions about MLPs. I'll try to answer the most common ones here,
and if you still have more at the end, I encourage you to reply to
this email and let me know.
Question #1: How do I pay taxes on my distributions from
Because MLPs don't pay taxes at the corporate level, you will
owe tax on any MLP distributions you earn. But the distributions
are heavily tax-advantaged, with most of your tax burden deferred
until you sell the MLP. Here's how it works.
MLP distributions are made based on the MLP's distributable cash
flow (DCF), which is similar to free cash flow (
This is important because an MLP's DCF is usually much higher
than its net income. That's because MLPs have significant
depreciation and other tax deductions, which lower their taxable
net income significantly. (This is why certain types of businesses
make better MLPs: huge tangible assets like oil pipelines have very
high depreciation expenses.)
So the money comes in, the MLP pays it out as distributions to
you and the other unitholders, then the MLP takes deductions on the
amount and reports its taxable net income to the government.
And, as you may have guessed, you only owe taxes on the portion
of your distribution that came from the MLP's net income-which the
MLP will inform you of in an annual form called a K-1.
You do have to pay regular income taxes on that portion of the
distribution (not the lower qualified dividend tax rate), but it's
usually only 10% to 20% of the total distribution.
What happens to the other 80% to 90% of the distribution?
The other 80% to 90% of the distribution is considered "return
of capital," and reduces your cost basis in the MLP.
So if you buy an MLP for $50, and receive an annual distribution
in your first year of $3.50, of which $0.30 is considered taxable
net income, your cost basis in the investment will be reduced by
$3.20 (the distribution minus the portion of the distribution that
is net income), to $46.80.
You do have to pay regular income taxes on the difference
between your original purchase price and your reduced cost basis
when you sell the MLP (at the same time you pay taxes on your
capital gains), but in the meantime, those taxes are deferred.
That's a big benefit to many investors who want to focus on
reducing their current tax liability on their investment income
(because they're living off it, or for other reasons). Plus, the
cost basis of the investment is "reset" to the current market value
if the original unitholder dies and passes on the investment. So
the new owner won't owe tax on the difference between the original
cost basis and the adjusted cost basis.
Question #2: Can I hold MLPs in my IRA?
This is a common question from investors considering buying MLPs
While you are allowed to hold MLPs in a tax-advantaged account
like an IRA, it is unwise.
That's because the IRS considers MLP distributions paid into an
IRA "unrelated business taxable income," or UBTI. And if your IRA
earns over $1,000 in UBTI (total from all sources, including
distributions from different MLPs) in a single year, your IRA will
be liable for paying tax on that income, at corporate tax
However, if you do most of your investing through an IRA and
would like to add the yield-boosting powers of MLPs to your
account, there is a way.
Funds that specialize in MLPs have given investors a way to
benefit from the income-generating power of MLPs without dealing
with K-1 forms and UBTI liability. And there are quite a few to
In fact, an MLP-focused closed-end fund was just recommended in
the latest Dividend Digest. This fund currently yields 5.6%, and is
a great way to add MLP-style high yields to any account. Here's the
recommendation, from the Forbes/ISA Closed End Fund and ETF
"We looked for ways to participate in the natural gas sector,
and in addition to ETFs that invest in the sector, we found a
dividend-paying closed end fund that trades at a discount.
ClearBridge Energy MLP Total Return Fund (
currently trades at a price of $21.40 and has a distribution yield
of 6.17%. Its net asset value of $21.49 gives the fund a discount
of -0.28%. The 52-week average discount for the fund is actually a
premium of 2.01%. The fund invests in energy master limited
partnerships that are engaged in the business of exploring,
developing, producing, gathering, transporting, processing,
storing, refining, distributing, mining or marketing natural gas,
natural gas liquids, crude oil, refined petroleum products or coal.
Its largest investment is in the Gathering/Processing of natural
gas at 34.7%, followed by Diversified Energy Infrastructure at
29.3% and Liquids Transportation & Storage at 18.1%. It is
leveraged at 25.93% and has a low expense ratio of only 0.76%. It
pays quarterly dividends."-Jack Colombo, Forbes/ISA Closed End Fund
and ETF Report, April 2013
Wishing you success in your investing and beyond,
Editor of Dick Davis Dividend Digest
and Dick Davis Investment Digest