Tax forms on distributions are filled out yearly.
Master Limited Partnerships (MLP) don’t pay any tax at the corporate level, provided their activities are considered qualified. Instead, quarterly distributions are passed directly to unitholders (investors); investors pay individual tax on their distributions. But MLP distributions are highly tax-advantaged and offer a significant tax shield for investors.
Because MLP distributions aren’t dividends, MLP unitholders don’t get a Form 1099 at tax time. Instead, unitholders receive a form K-1–a standard partnership form that’s typically mailed to unitholders in March.
But there are some big tax benefits to owning MLPs. Because of depreciation allowance, 80 to 90 percent of the distribution you receive from a typical MLP is considered a return of capital by the IRS. You don’t pay taxes immediately on this portion of the distribution.
Instead, return of capital payments serve to reduce your cost basis in the MLP. You’re not taxed on the return of capital until you sell the units.
In other words, 80 to 90 percent of the distribution you receive from the MLP is tax-deferred. The remaining piece of each distribution is taxed at normal income tax rates, not the special dividend tax rate. But the piece taxed at full income tax rates is only 10 to 20 percent of the total distribution; there’s still a huge deferred tax shield for unitholders.
An example can provide a useful illustration. Assume you own an MLP purchased for $50 and receive $5 in annual distribution payments, $4.50 of which is considered a return of capital. After one year, your cost basis on the MLP would drop to $45.50 ($50 minus $4.50); no income tax is paid on that $4.50. You’d pay normal income tax rates on the remaining 50 cents.