oil and gas partnerships and mlps

In short

A friend of mine once bought into an oil pipeline partnership because the yield looked like a paycheck that never stopped. Then tax season came, a stack of forms arrived late, and the whole thing felt like a puzzle with missing pieces. If you are holding units in one of these partnerships, or just learning how they work, you are in good company. A master limited partnership, called an MLP, is a business that trades on a stock exchange but is taxed like a partnership. Each owner gets a Schedule K-1 instead of a plain 1099, and the form often comes later than other tax papers. Part of what the partnership pays out is treated as a return of your own money, which lowers your cost basis, the number used to figure gain or loss at sale. A direct oil and gas partnership works differently, since it usually is not traded and can be hard to leave. Knowing these few facts first can save a good deal of worry.

The whole of it

What it is

I once sat with a retired schoolteacher who held units in a pipeline company. She could not tell me whether she owned stock or a piece of a business. She was not foolish. The thing really is a hybrid, and the names do not help.

A master limited partnership is a partnership whose units are bought and sold on a public exchange. The partnership itself pays no income tax at the entity level. Instead, the income, deductions, and credits pass through to the owners, who are called limited partners. The Internal Revenue Code, in section 7704, sets the rules for which publicly traded partnerships keep this treatment. In general, the law ties it to the kind of income the business earns. Income from natural resource activity, such as producing, processing, or moving oil and gas, can qualify.

A direct oil and gas partnership is a different animal. Here a sponsor pools money from investors to drill wells or buy working interests. Units are not traded on an exchange. The partnership agreement spells out what the sponsor does, what the investors get, and how hard it is to cash out. If you are weighing one of these, the agreement is the whole story, so it is worth reading slowly.

Both kinds pass income through. Both can carry tax features that look strange next to an ordinary stock.

How it works

A friend of mine told me he felt rich the first year his MLP units paid him a cash distribution. Then he learned that a distribution is not the same as income. That small gap is where the confusion lives.

Each year the partnership sends every owner a Schedule K-1. It lists the owner's share of the partnership's income, loss, and deductions. The owner reports those figures on a personal return, even if no cash was paid out. The reverse can happen too. Cash can arrive while little taxable income shows up on the form.

Part of a distribution is often treated as a return of capital. That means the partnership is handing back some of the owner's own money, not paying profit. A return of capital is not taxed right away. Instead, it lowers the owner's basis in the units. The owner tracks basis year by year. Share of income is added, and distributions and share of losses are subtracted. When the units are sold, the gain is the sale price less the adjusted basis. Because basis has been shrinking, the taxable gain can be larger than a person expects. Part of the gain may also be taxed as ordinary income rather than at long term rates, because of depreciation recapture rules the partnership reports on the K-1.

Direct oil and gas partnerships carry their own tax features. The tax code has allowed certain drilling costs, called intangible drilling costs, to be deducted. It has also allowed a depletion deduction as the oil or gas in the ground is used up. IRS Publication 535, Business Expenses, covers depletion. These deductions can lower taxable income for a time. They also affect basis and what is owed later.

There are other quirks worth knowing. An investor who holds an MLP inside an IRA can run into unrelated business taxable income, often shortened to UBTI. The instructions for IRS Form 990-T, Exempt Organization Business Income Tax Return, explain when a tax exempt account must file that form and may owe tax. The filing threshold is the current figure, which the official source publishes each year. Some states also ask for a return where the partnership does business. And the K-1 often lands in March or even later, so a return may need an extension.

The numbers, and where to find yours

I have noticed that people feel calmer once they know which piece of paper holds which number. So here is where to look.

Your Schedule K-1 from Form 1065 comes from the partnership each year. Box 1 shows ordinary business income or loss. The box that reports distributions can change from one form version to the next. The instructions for the current Schedule K-1 name the right one. Many K-1 packages also include a basis worksheet or a supplemental statement, and it is worth keeping. Your broker's year end statement shows the cash you were paid. The K-1 is what controls the tax return.

The passive activity rules matter here. Under section 469 of the Internal Revenue Code, losses from a passive activity can generally offset only passive income. A publicly traded partnership gets its own separate bucket. So a loss from one MLP can generally offset only income from that same MLP. IRS Form 8582, Passive Activity Loss Limitations, is where this gets worked out, and its instructions explain the details.

One more item deserves care. Section 199A of the Internal Revenue Code allows a deduction for qualified business income. Its text also names qualified publicly traded partnership income, and the IRS instructions for Form 8995 and Form 8995-A describe how that income is handled. Whether and how the deduction applies to your MLP income depends on your own situation, so read those instructions or ask a preparer. The deduction rate set by law is the current figure, which the official source publishes each year, and the income thresholds that limit it are the current figure, which the official source publishes each year. The site fills in the current verified figures with their sources and dates, so check there for today's numbers.

A worked example

A man I will call Walter once told me, with some embarrassment, that he never kept track of his basis. So let us walk through a simple case with plain figures, and let Walter be our guide.

Walter buys 1,000 units of an MLP at $20 a unit. His starting basis is 1,000 units at $20, which is $20,000.

In year one, the partnership allocates $800 of taxable income to Walter and pays him $1,500 in cash distributions. His basis goes up by the $800 of income and down by the $1,500 of distributions. So $20,000 plus $800 minus $1,500 is $19,300.

In year two, the partnership allocates $400 of income and pays $1,500 again. Basis becomes $19,300 plus $400 minus $1,500, which is $18,200.

In year three, the allocation is $300 and the distribution is $1,500. Basis becomes $18,200 plus $300 minus $1,500, which is $17,000.

Then Walter sells all 1,000 units at $21 each, for $21,000. His gain is $21,000 minus the adjusted basis of $17,000, which is $4,000. Had he ignored basis and used his $20,000 purchase price, he would have thought his gain was only $1,000. That is a $3,000 gap.

Some of that $4,000 may be taxed as ordinary income because of recapture, and the K-1 reports how much. The rest may be a capital gain. Walter should read the K-1 and the sale reporting instructions, or ask a tax preparer to sit down with him.

The lesson is plain. Cash received is not income, and basis keeps score.

Where it goes wrong

I have seen smart people get tripped up here, and no one should feel foolish about it. The traps are easy to miss because they hide in paperwork.

The first trap is the late K-1. A person files early, then a K-1 shows up and the return has to be amended. The partnership must send the form, but the timing follows its own work. An extension is often wise.

The second trap is basis that no one tracked. When basis is lost or guessed at, the gain on sale can be misreported. The seller has to rebuild basis from the K-1s. That is much easier to do each year than all at once.

The third trap is the IRA. A person holds an MLP in a retirement account and later learns about unrelated business taxable income. The account itself may owe tax and file Form 990-T. That surprises people.

The fourth trap is the passive loss limit. Losses can sit unused, carried forward, until income from the same source appears or the units are fully sold. People expect the loss to help right away, and it often cannot.

The fifth trap is thin trading in direct partnerships. Units in a direct oil and gas program are not on an exchange. The partnership agreement may limit transfers, so an owner may not be able to leave when he wants. Read that part before signing.

The sixth is cost. Sponsors can charge fees for sales, management, and drilling. Those fees sit in the offering documents. Costs reduce what an investor keeps, so they deserve a careful look.

Each of these is manageable once it is seen. None of them means a person made a poor choice. They just show that the form of the thing matters as much as the thing itself.

Questions to answer before you leave this page

Do you know whether you hold units that trade on an exchange or a direct interest that does not? Have you found your latest Schedule K-1, and do you know which box shows your income and which shows your distributions? Can you say what your adjusted basis is today, and where you wrote it down? Is the account that holds the units a taxable account or an IRA, and has anyone checked for unrelated business taxable income? Do you understand which losses can be used now and which are carried forward under the passive activity rules? Have you read the partnership agreement or prospectus for fees, transfer limits, and what happens when you want out? And have you asked a tax preparer who knows partnership returns to look over your K-1 before you file?