MLP K-1 Tax Reporting: What You Need to Know

Master Limited Partnerships (MLPs) offer investors high yields and tax advantages but come with complex tax reporting requirements. Unlike traditional stocks that issue a simple Form 1099, MLPs provide a Schedule K-1, detailing various types of income and deductions that must be reported on a tax return.

Understanding how to interpret and file a K-1 is essential for avoiding errors and potential IRS issues.

MLPs as Pass-Through Entities

MLPs are structured as pass-through entities, meaning they do not pay corporate income tax at the federal level. Instead, income, deductions, and other tax attributes flow directly to investors, who report them on their personal tax returns. This avoids the double taxation that corporations face, where earnings are taxed at both the corporate and shareholder levels.

Tax liability is based on each unitholder’s share of the partnership’s earnings, regardless of whether cash distributions are received. This differs from traditional dividend-paying stocks, where taxes are owed only on actual payments received. Publicly traded partnerships are generally taxed as corporations, but an exception exists for those earning at least 90% of their income from qualifying sources, such as natural resource extraction, transportation, and processing.

MLPs offer tax benefits such as depreciation and depletion deductions, which can reduce taxable income. However, tax reporting can become complicated, especially when units are bought or sold during the year.

Key Items on Schedule K-1

Schedule K-1 details an investor’s share of an MLP’s income, deductions, and credits. Unlike a Form 1099, which reports straightforward dividend or interest income, a K-1 includes multiple categories of taxable and non-taxable amounts that must be reported in different sections of a tax return.

Ordinary Income

Ordinary business income (or loss) is reported in Box 1 of Schedule K-1. This represents the investor’s share of the partnership’s net earnings from operations and is taxed at regular income tax rates, ranging from 10% to 37% in 2024.

This income is not necessarily tied to cash distributions. An investor may owe taxes on their allocated share of earnings even if they received no cash payments. However, MLPs often generate depreciation and other deductions that can reduce taxable income.

For example, if an investor owns 1,000 units and the partnership reports $5 per unit in ordinary income, the investor must report $5,000 as taxable income, even if they received no cash distributions. This income is reported on Schedule E of the tax return.

Capital Gains

Capital gains arise when the partnership sells assets or when an investor sells their units. Long-term capital gains, for assets held more than a year, are taxed at 0%, 15%, or 20%, depending on income level. Short-term capital gains, from assets held one year or less, are taxed at ordinary income rates.

A unique aspect of MLP taxation is the potential for “recapture” of prior depreciation deductions when units are sold. This recaptured amount is taxed as ordinary income rather than at capital gains rates. For example, if an investor sells MLP units for a $10,000 gain but has $3,000 in depreciation recapture, only $7,000 qualifies for capital gains treatment, while $3,000 is taxed at higher ordinary income rates.

MLPs may also allocate capital gains from asset sales directly to investors, which appear in Box 9a (Net Long-Term Capital Gain) or Box 10 (Net Short-Term Capital Gain) of the K-1. These amounts must be reported on Schedule D of the tax return.

Dividends

MLPs generally do not pay traditional corporate dividends. However, if an MLP receives dividend income from investments in corporate stocks, this income is passed through to investors and reported in Box 6a (Total Dividends) and Box 6b (Qualified Dividends) of Schedule K-1.

Qualified dividends are taxed at lower capital gains tax rates (0%, 15%, or 20%), while non-qualified dividends are taxed at ordinary income rates. These amounts must be reported on Schedule B.

Distributions

Cash distributions from an MLP, reported in Box 19 of Schedule K-1, are not immediately taxable. Instead, they reduce the investor’s cost basis. If cumulative distributions exceed the original investment, further distributions are taxed as capital gains.

For example, if an investor buys MLP units for $50,000 and receives $5,000 in distributions, their adjusted basis decreases to $45,000. If they later sell the units for $60,000, the taxable gain is $15,000.

Passive Activity Rules

The IRS classifies MLP income as passive, meaning losses can only be deducted against passive income from other activities. Passive activity rules prevent investors from using MLP losses to offset wages or portfolio income. Instead, passive losses are carried forward until passive income is available to offset them.

For investors holding multiple MLPs, passive income and losses are tracked separately for each partnership. If an investor disposes of their entire interest in a loss-generating MLP, any suspended passive losses tied to that partnership become fully deductible.

Basis Tracking Methods

Tracking the cost basis of MLP units is necessary for determining tax liability. Since MLPs distribute cash that is not immediately taxable, an investor’s basis fluctuates with each distribution, allocation of income, and other partnership activity.

Adjustments to basis occur annually based on Schedule K-1. Positive adjustments include allocated income and depletion recapture, while negative adjustments result from distributions and depreciation deductions. Brokerage statements may not accurately reflect these adjustments, so investors must track basis separately.

If additional units are purchased at different prices, the IRS allows multiple methods for tracking basis, including specific identification, first-in, first-out (FIFO), or an average cost approach. Investors who inherit MLP units receive a step-up in basis to the fair market value on the date of inheritance.

Tax Treatment on Sale

Selling MLP units triggers a complex tax calculation due to basis adjustments. Unlike traditional stocks, where gains or losses are simply the difference between purchase and sale price, MLP sales involve capital gains, ordinary income, and potential depreciation recapture.

When an investor sells MLP units, the total gain is divided into two parts: the portion attributable to basis reductions, which is taxed as ordinary income, and the remaining amount, which is taxed as capital gains.

Additionally, selling MLP units may trigger state tax obligations if the partnership operates in multiple states. Investors may be required to file tax returns in states where the partnership conducted business, even if they are not residents.

State Filing Obligations

Investing in an MLP can create state tax complexities. Many states require nonresident investors to file a tax return if they receive income sourced from that state. Some MLPs provide composite tax filings, where the partnership files a group return on behalf of all investors, reducing individual filing burdens.

Submission Requirements

Filing taxes with an MLP investment requires careful attention to detail, as Schedule K-1 information must be reported correctly. K-1s are often issued later than Form 1099s, sometimes as late as mid-March or April, which can complicate tax filing.

If an investor receives a corrected K-1 after filing, an amended return (Form 1040-X) may be necessary. Some investors choose to file for an extension using Form 4868 to allow additional time for K-1 processing. Keeping detailed records of basis adjustments and prior-year K-1s can help streamline tax preparation.