Publicly traded partnerships: Investors' tax considerations.

• Author: Hinson, Laura

Imagine that you are a fairly sophisticated investor and your broker has added a publicly traded partnership (PTP) to your portfolio. You trust your broker to invest wisely on your behalf, but you have heard that owning a PTP is a little different than typical stock ownership and presents unique challenges. You wonder whether this will be a fruitful investment.

Let us compare a PTP investment to the time the sister of one of the authors brought her 15 pounds of lemons from the tree in her backyard. It was nice of her to share the fruits of her labor, but what is a person supposed to do with 15 pounds of lemons? Lemons are great, but what happens when you are tired of lemonade?

A similar issue may arise with a PTP investment: Is investing in a PTP prudent? Is having it more trouble than it is worth? If your investment adviser proposes a PTP as part of your investment strategy, what should you be thinking through from a tax perspective? PTPs may offer the opportunity to diversify a portfolio and provide cash flowthrough distributions, but, unlike simpler investments such as stocks, they have the added complexity of partnership reporting requirements.

This article explores tax planning aspects of holding interests in PTPs. These investments have become popular since their introduction in 1981. Sec. 469(k)(2) defines a PTP as any partnership where the "interests in such partnership are traded on an established securities market" or "are readily tradable on a secondary market (or the substantial equivalent thereof)." In response to the popularity of PTPs, the Revenue Act of 1987 (1) added Sec. 7704 to prevent most PTPs from being treated as flowthrough entities. Sec. 7704 provides that a PTP is taxed as a corporation unless 90% of its gross income consists of "qualifying income," which can generally be thought of as passive income or income from certain oil and gas endeavors. As a result, PTPs are common in the real property or natural resource industries because they produce "qualifying income" that allows the PTP to be taxed as a partnership.

There is an argument that a PTP can be a wise investment. But some people may feel these assets are like 15 pounds of lemons because of tax compliance and other issues. This article begins by addressing general implications of PTP investments for Form 1040, U.S. Individual Income Tax Return, then discusses considerations for monetizing the tax losses these partnerships often generate, and finally explores tax issues that arise when gifting or donating a PTP interest.

General implications for Form 1040

Understanding how PTP investments are taxed is crucial. Whereas stocks return cash to investors in the form of dividends, PTPs return cash to investors through partnership distributions. Partners in a PTP are taxed on their share of the partnership's income and deductions, while stock investors are taxed on their share of dividends received. To be clear, as with any flowthrough entity, a PTP's investors are not taxed based on the cash they receive; they are taxed based on the income allocated to them. The income is reported on Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc.

Often, the Schedule K-l packages are lengthy, containing not only federal information that needs to be accounted for on the investor's tax return but also foreign reporting and state income tax reporting. Investments in PTPs can cause investors to file additional foreign reporting forms such as Form 926, Return by a U. S. Transferor of Property to a Foreign Corporation, or Form 965, Inclusion of Deferred Foreign Income Upon Transition to Participation Exemption System. Further, a single PTP investment can result in the need for multiple state income tax filings per year, when the partner's share of income is allocated across the various states in which the PTP operates or invests. Some PTPs also invest in underlying PTPs, which, for reasons discussed later in this article, can significantly complicate loss tracking and income tax reporting.

Sec. 199A: The Sec. 199A qualified business income deduction has added complexity to PTP K-ls. Sec. 199A attributes have to be reported on an activity-by-activity basis, and PTPs can have many underlying activities (many of which may be PTPs that the PTP has invested in) that then must be accounted for on the individual's tax return.

Basis: The cash distributions from PTPs may make this all worth the effort, but investor beware: You should make sure you are not out of basis. When a PTP reports a loss to its partner in a tax year, loss limitation...