Unconventional Income From Uncommon Stocks – MLPs

This is part II of the series, Unconventional Income From Uncommon Stocks. The series is meant to be an absolute beginner’s introduction to uncommon stocks. The focus of this post is on MLPs.

Why MLPs?

Before I answer this question, here’s one for you! What’s strikes you as most unusual from this list of MLPs?

Master Limited Partnerships
Market Cap
Div Yield
INDUSTRY AVG6,1534.537.6

To be impartial, I picked every 5th stock from Morningstar’s data for industry peers for one of the largest MLPs, Kinder Morgan Partners

If you felt the dividend yields were quite attractive, congratulations! You have your eye on the money! One of the characteristics of MLPs is that they pay generous dividends and most have attractive yields. In fact, MLPs are required to pay out at least 90% of their income as distributions to it’s investors.

How Do MLPs Manage To Pay Out Fat ‘Dividends’?

What are mlps and what are the risks and benefits
If MLPs are required to pay out 90% of their income, how do they stay in business? Not paying corporate taxes is a good start! That’s right, MLPs don’t pay any taxes either at the Federal or the State level. Instead, that burden is passed on to you, the investor!

Which is not necessarily a bad thing. This avoids double taxation other regular corporations are subjected to. Taxed once at the corporate level and again at the individual investor’s level on dividends.

No Corporate Tax? Why Aren’t More Companies Joining The Party?!

Now not having to pay corporate taxes is very attractive for any business. Some go to great lengths to avoid paying taxes! What’s stopping a regular corporation from becoming an MLP?


Not all companies can become an MLP. A business needs to meet certain criteria in order to qualify for MLP status.

  • The business must generate at least 90% of its income from ‘qualifying sources’ as defined by the IRS
  • These include activities related to real estate, commodities or natural resources
  • An MLP must pay quarterly required distribution as outlined in the partnership agreement

In order to satisfy the last point, an entity must have a source of income that is very stable and recurring in nature. No wonder most MLPs are in the energy transportation (pipeline) business!

What Is An MLP?

MLP stands for Master Limited Partnership. MLPs are publicly traded partnerships. By buying MLP shares (called units) you become a partner (unitholder) and you pay your share of the partnership’s taxes.

Why Should You As An Investor, Care About MLPs?

MLPs are a sweet deal for businesses. What about the investor? Other than fat dividends (not a guarantee, mind you), why should an investor look at MLPs?

In order to understand the benefits of investing in MLPs, let’s compare investing equal amounts of money in two hypothetical companies – one is a regular corporation and the other example is an MLP.


  • Capital Gains Tax assumed at 15%
  • Income Tax Rate assumed at 30%
  • In reality, these two rates vary depending upon your income limits
  • Amounts in red indicate cash going out of your pocket, amounts in black indicate cash coming in

Example: Regular Dividend Paying Corporation

AYou buy 1000 shares at $10 a share-$10,000
BAnnual Dividends at $1 per share$1,000$1,000$1,000
CDividends taxed at 30%-$300-$300-$300
DYou sell 1000 shares at $12 a share$12,000
ECapital Gains Tax at 15%-$300
GCASH FLOW-$-$9,300$700$12,400$3,800

The tax impact of buying shares in a regular dividend paying corporation is fairly straightforward.

  • (A)You purchase shares
  • (B)You may receive payments from the company called dividends
  • (C)You pay taxes on the dividends received at your regular income rate
  • (D)When you sell the shares, you pay taxes on any profit made at your capital gains rate (E)

Example: Master Limited Partnership

AYou buy 1000 units at $10 a unit-$10,000
BCash Distribution of $1.50 per unit$1,500$1,500$1,500
CYour portion of MLP's taxable income at $0.50 a unit,
taxed at 30% rate (1000*0.50*30%)
DYou sell 1000 units at $12 a unit$12,000
ECapital Gains Tax on difference
between sale price and purchase price ($12,000-$10,000)*15%
FIncome Tax on difference between
original purchase price and adjusted price ($10,000-$7,000)*30%
GCASH FLOW-$8,350$1,350$12,150$5,150

The tax impact of investing in an MLP is a little more involved.

  • (A)You purchase units as you purchase shares in any other regular corporation
  • (B)You receive quarterly payments from the MLP called distributions instead of dividends
  • (C)The MLP will notify you of your share of the Partnership’s income
  • (C)Unlike dividends, you don’t pay taxes on the entire amount of the distribution. You only pay income tax on your share of the income which is usually 10% to 20% of that year’s distribution, essentially differing taxes on the rest of the distribution till you sell your units! Tax deferral is one of the key advantages of an MLP
  • (D)You sell units like you sell shares of a regular corporation essentially terminating your partnership in the MLP when you liquidate all your holdings in the MLP
  • (E)Just like a regular stock sale, you pay Capital gains tax on any profit you made (difference between original purchase price and final sell price)
  • (F)Here’s the part that confuses most! When you purchase a share of a regular corporation, the cost remains the same till you sell it (known as cost basis). In an MLP, your cost basis can actually go down every year you have a distribution (less taxes)! How? Because the distribution after taxes is treated as return of capital by IRS!
  • To elaborate on the above point, the purchase price at the beginning is $10000, but in Year II, the cost basis is set at $9000 and $8000 in Year III! In fact this can go on till your recover all of your capital and the cost basis can go to 0 if you hold the MLP long enough!
  • (F) To understand how the $7000 adjusted cost basis was arrived at, study the table below

Calculating Adjusted Cost Basis (MLP)

STARTING BASIS$10,000$9,000$8,000
LESS CASH DISTRIBUTIONS-$1,500-$1,500-$1,500
ADJUSTED BASIS$9,000$8,000$7,000

If the investor continues to hold this MLP, assuming the distributions and income share remain constant (in reality, both varies, but to simplify this example, we’ll keep these constant), in year 10, the adjusted cost basis goes to zero!

Frequently Asked Questions (FAQ)

1. How do I know what my portion of an MLP’s taxable income is?

Just before tax time, MLPs send out a form called Schedule K1 to all its unitholders. This details the amount you owe among other details like deductions caused by depreciations.

2. Can I hold MLPs in a tax deferred account like an IRA?

Yes (some brokers may not allow this). Considering the additional paperwork involved with MLPs some hold them in IRAs. But this is not the most efficient use of an IRA. Most of an MLPs distribution is tax-deferred, hence keeping it in an already tax-deferred account isn’t very prudent.

Some MLPs provide I-Shares (Institutional shares) that mimic the corresponding MLP and safe to hold in retirement accounts.

3. Why doesn’t my broker allow holding an MLP in my IRA? Why does the broker care?

Some brokers simply don’t allow holding MLPs in a retirement account and they have a very good reason for doing so. This is due to a tax concept called Unrelated Business Taxable Income (UBTI).

In order to understand UBTI, consider a tax-exempt entity like a hospital or a university that earns profits from their food services or parking departments. These are essential services, but have nothing to do with the purpose for which these entities have been provided tax-exempt statuses! These will be treated as UBTI.

In a similar fashion, income generated by an MLP in a retirement account may be treated as UBTI. As long as UBTI generated by all such entities is less than $1000 per year, the account will not be subject to taxes. Anything beyond and the entity is subject to UBTI taxes.

Yes, one of the rare instances where holdings in a retirement account is subject to taxes.

Why should your broker care? Because, it is not you who’ll file this (form 990-T) but your custodian! And in order to avoid this, some brokers won’t permit MLPs in an IRA and other brokers charge a hefty fee if UBTI is triggered. Please check with your broker before adding MLPs to your retirement account AND you expect to cross the $1000 threshold.

4. How do I know my MLP’s UBTI?

Check Box 20, Code V in your MLPs Schedule K-1. If the sum total in box 20-V of all the MLPs held in your retirement account is greater than $1000, your custodian, not you, will have to file 990T and pay taxes.

5. “I like the benefits MLPs provide, but don’t want to deal with the additional paperwork come tax time”

If, after reading this post, you still aren’t convinced MLPs are worth the additional paperwork, then these are some alternatives you could consider!

1. MLP ETFs. You could invest in MLP ETFs that’ll send you a 1099 instead of Schedule K-1s. AMLP, Alerian MLP ETF tracks 25 MLPs from the Energy sector tracking Alerian MLP Infrastructure Index. This is also the first MLP ETF launched in 2010.

2. MLP ETNs. An alternative to ETFs are ETNs – Exchange Traded Notes. Similar to MLP ETFs, ETNs send you form 1099 instead of Schedule K-1. Unlike ETFs, ETNs carry credit risk. (AMJ, MLPN)

3. MLP Mutual Funds. If you like an actively managed fund, you can choose between Closed End Mutual Funds like SRV and TYG or an Open End Mutual Fund like SteelPath (MLPAX).

4. I-Shares. If you’d like to hold MLPs in a retirement account without having to worry about UBTI, invest in an I-Share (Institutional Shares). They pay distributions as shares and meant for holding in tax deferred accounts. EEQ and KMR both track their respective MLPs, EEP and KMP respectively.

5. Import Schedule K-1′s. If you don’t mind Schedule K-1′s but hate entering all that data manually come tax time, then I have the perfect solution for you! You can automate entering Schedule K-1s if you have Turbo Tax!

Closing Thoughts

For a little bit of paperwork during tax time, MLPs provide relatively stable, tax-deferred income most suitable for taxable accounts. You not only get to enjoy regular payments, but get to bring down your cost basis with each distribution. And since the General Partner’s compensation is tied to the Limited Partner’s distributions, this serves as an incentive to maximize and grow distributions.

Disclosure/Disclaimer: Long on KMP. Meant for informational purposes only and should not be construed as investment advice. Not responsible for errors and omissions. Please consult your tax advisor.

If you liked this post, don’t miss Part I of this series, Unconventional Income From Uncommon Stocks – Royalty Trusts. Sign up to receive FREE future updates on this series.

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25 thoughts on “Unconventional Income From Uncommon Stocks – MLPs

  1. This is a very good and well written explanation. With a wide range of investments including real estate and partnerships, I decided to go with an accountant to prepare my taxes. It is one of the best moves I ever made and took tons of stress out of my life. It is worth every penny to have weeks of my life back.

  2. Nice explanation! I’ve owned KMP on and off over time, and have loved them! I do like MLPs.

  3. Excellent examples. I’ve been thinking of using AMLP in client accounts.

  4. This is fascinating Moneycone! This is the first time I’ve ever heard of MLP’s so thanks for teaching me something new today. :) 90%+ of income paid out as distributions to investors is such a foreign concept to me but them not having to pay corporate taxes makes sense. -Sydney

  5. Terrific and detailed breakdown. I never heard of MLPs until today. Thanks for the education!

  6. I agree with Buck, nice breakdown and explanation of MLPs. I have been a pretty big fan of them for quite awhile, I hold many myself.

    Selling Theta

  7. Hi MC – super article on MLPs. I’ve held and currently hold couple of MLPs in my 401K, with the UBTI under $1000.

    • To trigger UBTI, one needs to be heavily invested in MLPs in a retirement account. Enjoy the yields without all the paperwork!! :)

  8. Great breakdown! Really good post here.

    I’ve read about MLPs before on several occasions, and was intrigued a bit, but never went any futher with it. Thanks for providing more detail here, and more food for thought.

  9. Thanks for giving me my Saturday project: find MLPs that pay monthly. Well written and very in depth.

  10. I’ve owned a variety of MLP’s over the years. Like every other investment, the share price can go up and down. The fat dividends are awesome. It’s not so great when the share price drops a lot! Not even a large dividend can make up for a 50% or more drop in share price. As with any investment, it’s important to do one’s homework.

    • Absolutely Barb! As with any other stock, there are no guarantees. Know your options, do your research, align it with your temperament and then invest. That’s my motto!

  11. Thanks for the excellent breakdown on MLP’s. I haven’t invested in any yet, due to my fear of the K-1. I do my own taxes.

    I had a comment about the math, however. The current tax rate on dividends is 15%, regardless of your income level. That would change the scenario a little. It certainly doesn’t change the fact that investing in MLP’s is extremely attractive, and something I should consider in the future. But, using the current 15% tax rate on dividends will make investing in normal corporations appear a little more attractive.

    Thanks for the excellent article!

    • That is true. With MLPs I like the fact that only 10%-20% in most cases are taxable at income rates and the rest tax-deferred till you sell or till your cost basis goes to zero.

      Thanks for sharing your thoughts DM!

  12. Excellent post MoneyCone, MLPs are good candidates for covering the income part of a portfolio.

    • Investors hesitate due to the tax complications – but it really isn’t that hard once you comprehend the reasoning behind it.

  13. Howard Schubert says:

    “As long as UBTI generated by all such entities is less than $1000 per year, the account will not be subject to taxes.” IRC section 469(k) prevents offsetting passive gains from one mlp with passive losses from another. Why wouldn’t that apply here?

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