One of the main reasons MLPs are particularly attractive right now is that the income they receive is tax deferred. MLPs are partnerships, so they are not subject to state and federal income tax as a corporation would be. This means the tax responsibility is shifted to the partners, who are then taxed at standard income rates. Therefore, as income tax rates for investors are lower than the rates of corporations, quarterly distributions from MLPs are shielded from income taxes into tax-deferred accounts.
So with yields currently at six percent, which have historically increased by five to six percent annually, investors receive 80-90 percent of the income earned from MLPs. According to David Grecsek, Director of investment strategy and research for Aspiriant LLC, these are significantly higher returns than utilities and REIT indexes, and 2.5 percent higher than the ten-year Treasury.
“No other asset class has the combination of above-market yields, growth in distributions and tax-deferral benefits,” Grecsek explained. “They’re a slam dunk for long-term client portfolios.”
Tax deferred
The right MLP plays can provide tax-advantaged cash flow for investors seeking strong fundamentals. These investors receive 85% of an energy MLP’s distribution on average as non-taxable return of capital, with only 15% subject to tax under current IRS rules. Although distribution proportions are subject to change over time, the return of capital distributions lower investor taxes, which increases the cash flows when MLP units are sold. Therefore, if investors are patient with their MLP units by holding on to them to receive steady distributions, their tax basis could reduce over time as well.
One of the primary drivers for MLPs is that investors receive 80-90 percent tax deferred income on average. However, if their distribution is less than their basis, the distribution is 100 percent tax deferred. The way this works is that an investor’s share of the net taxable income is approximately 20 percent of the tax deferred cash distribution.
Ideal estate planning vehicle
MLPs are also estate tax-free, making them an ideal estate planning vehicle for high net worth families. All income earned from MLP distributions is deferred due to the current IRS tax laws, which means that heirs pay no income tax on the accumulated deferred growth of the assets.
As with most securities, MLP units receive a basis step-up to current market value in the event of the investor’s death. This means that heirs receive the MLP units with fresh fair market value basis, and all previous distributions remain tax deferred. These MLP units then have the potential to become completely tax free for heirs with the step-up in cost basis.
What investors need to know about MLP tax status
MLPs avoid state and federal income taxes as long as they are held by investors, but the distributions turn into cash when an investor sells their shares. Therefore, this income earned from selling off assets is subject to traditional income and capital gains taxes, meaning that MLPs are not tax efficient for short term investors.
Takeaway
MLPs are an ideal investment vehicle because they offer the tax benefits of limited partnerships and the liquidity of exchange traded securities. These tax benefits make MLPs strong additions to portfolios for high net worth investors seeking to transfer wealth to the next generation through their estate. The investor receives the benefits of steady yields with growth opportunities, while the income tax is deferred for their heirs.