Unintended Tax Consequences of Investing in Publicly Traded Partnerships (PTP)

Does this sound familiar? Your broker calls to tell you he has a great opportunity for you to invest in some publicly traded partnerships. He tells you how its a sound investment that distributes income each year. But wait, there’s more! Not only will this investment yield high returns but it will also be tax free. This sounds like a great investment but it will have unintended consequences when it comes time to dispose of these investments. This blog post will detail the pros and cons of publicly traded partnerships as an investment and also warn against their unintended tax consequences.

What Is A PTP?

Publicly Traded Partnerships (PTP), also referred to as Master Limited Partnerships (MLP), are publicly traded business organizations that have two or more co-owners. The majority of PTPs engage in oil, gas and other energy related activities. You will often see such terms as, “pipeline”, “energy” or “midstream” in the name of the PTP.

PTPs are often used as an alternative investment tool because they are committed to distribute all earnings not needed for current operations to investors. PTPs offer high returns like equities while also paying out regular “dividends” in the form of partnership distributions. Since the cash distributions from a PTP are considered a return on capital, they are not taxed as long as the distributions don’t exceed the partners adjusted basis.

PTPs are different from traditional investments like stocks and bonds because the investor receives a k-1 at the end of the year. When an investor decides to buy into a PTP they are actually buying a unit of ownership, therefore making them a limited partner. The earnings of the partnership are then taxable regardless if a distribution is made. However, PTPs traditionally mask partnership profits through depreciation. This means that the partnership will have cash income to distribute while showing little to no income on the k-1s.

So to recap, PTPs are an alternative investment tool with high yields and attractive tax benefits. So are PTP investments too good to be true?

Increased Accounting Cost

PTPs may be great investment tools but they are a nightmare when it comes to tax time. For traditional stocks and bonds investors will receive a consolidated 1099 showing the interest, dividends, capital gains/losses and any other investment income. A portfolio with hundreds of different investments will all be summarized on one statement and can be easily entered into a tax return.

PTPs on the other hand are standalone investments; this means that for each PTP you invest in you will receive a corresponding k-1. Some PTPs are subsidiaries of other larger PTPs and will often be consolidated onto one K-1. However, this is still an increase in the number of tax documents you will receive and will significantly increase the time it takes to complete your tax return.

Additionally, since PTPs are standalone investments, the k-1s will not always come in at the same time. If you invest in 10 PTPs and receive 10 individual PTP k-1s then you will have to wait until all 10 k-1s come in to complete your return. It is not uncommon for PTP k-1s to be unavailable before April 15th so this means your tax return could potentially be put on extension.

Gain On Sale Of PTP

Even though the distributions from PTPs are generally tax free, the tax burden comes when the PTP is sold. The distributions of PTPs are not only tax free but they also reduce the adjusted basis in the investment. This means that the taxable income from the PTP will be built in to the investment in the form of short term or long term capital gains.

Say for example an investor buy units into a PTP for $10,000. Over the course of a few years the investor receives $6,000 in distributions and reports $2,000 in taxable income from a k-1. Lets say the investor wants to sell the PTP and is able to get $14,000 for this investment. The original basis in the invest of $10,000 would increase by $2,000 (income reported on k-1) and decrease by $6,000 (distributions) netting to a $6,000 cost basis at the time of sale. Everything held constant, the taxpayer will report a $8,000 long term capital gain from the sale of the investment.

There are also other tax issues to consider with the sale of a PTP. For example, the sale of a PTP may be subject to recapture gains that will be taxed at higher rates than regular long term capital gains. Additionally, there are other items on the k-1 that impact the basis of the PTP and ultimately the capital gain or loss.

Overview

Although PTPs might seem like a great investment alternative, taxpayers should do their due diligence before jumping into PTP investments. If the return on investment is worth the added accounting fees and investors are aware of the tax treatment at the time of sale then PTPs might be a viable option.