Publicly traded partnerships: Tax treatment of investors.

• Author: Drnevich, Dawn

Publicly traded partnerships (PTPs) have become popular investment vehicles as investors look for higher distribution yields than stocks are paying. (1) Unfortunately, what is often touted as "dividend income" are really partnership distributions that cannot be directly compared to dividends paid by corporations.

For example, the December 2017 issue of Kiplinger's Personal Finance has an article, "Our Top Dividend Picks," that lists two PTPs as high-yield dividend companies (Blackstone Group and Enterprise Products Partners) but only identifies one of them as in fact a partnership and the "dividends" as distributions. (2) To an unknowing investor, the discussion of cash flow and the high yield from a PTP might seem attractive, especially if the investor is unaware of any tax reporting requirements of PTPs beyond what is required when holding stock in a company. This could cause a tax reporting nightmare for the investor.

Investing in a PTP is as simple as buying stock in a corporation, but the similarity stops there. The investor owns an interest in a partnership and is treated as a limited partner (or a member, in the case of a limited liability company (LLC)) of a flowthrough entity. There are numerous tax implications of investing in a partnership, some of which are not favorable, that investors should be aware of when making an investment in a PTP. To start, the investor will receive a Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., listing the annual flowthrough tax information as opposed to a Form 1099-DIV, Dividends and Distributions, which is received when investing in a corporation. Further, because of the complexity in completing the Schedule K-1, a taxpayer may not receive it until shortly before or even after April 15, requiring the individual taxpayer to file for an extension of his or her tax return.

Many PTP investments are said to carry a high "dividend" yield. This is a misnomer, in that the cash received is treated as a return of tax basis in the partnership interest. (3) The distribution does not necessarily correspond to a distribution of income. This is in stark contrast to a dividend distribution received from a corporation that, by definition, is a payment from the corporation's earnings and profits (4) and currently may receive preferential tax treatment. (5) A cash distribution from a PTP, although it is not currently taxable, will reduce the owner's tax basis in the partnership interest. (6) The end result will be a larger gain or a smaller loss when the PTP interest is eventually sold, with the possibility of ordinary income being generated because of Sec. 751(a), under which any amount received by a partner in exchange for all or a part of the partner's interest in the partnership attributable to its unrealized receivables or inventory items is considered realized from the sale or exchange of property other than a capital asset.

Prior literature has often discussed investing in a PTP from a general perspective without regard to an understanding of PTPs from a tax investment perspective. (7) Missing in the discussion of PTPs are the often-complicated reporting requirements for individual investors in completing their annual income tax return (8) and possible traps for tax-exempt investors due to unrelated business taxable income issues.

This article discusses the detailed and often-complicated tax reporting requirements and analyzes the tax implications for individual investors when they own or sell an interest in a PTP. It does not discuss the economics of the investment, but rather summarizes the tax implications and reporting requirements of holding a partnership interest. The article compares owning corporate stock with owning a PTP interest to illustrate the differences between those two investments and suggests other ways of investing in a PTP to make the the tax reporting for individuals much easier.

Publicly traded partnerships

A PTP is any partnership if interests in the partnership are traded on an established securities market or interests in the partnership are readily tradable on a secondary market or its substantial equivalent. A PTP is in general taxed in the same manner as a corporation since it is treated as an association for tax purposes. (9) However, this rule does not apply to PTPs if 90% or more of their gross income is certain types of passive income. These PTPs, which are the focus of this article, (10) are generally treated as partnerships and are not subject to an entity-level federal income tax. (11) Many PTPs can be found in specific industries such as oil and gas, (12) and a current list of PTPs can be found at suredividend.com/mlp-list or by referring to the Alerian MLP Index. A PTP investor will receive an annual Schedule K-1 detailing the flowthrough tax information for the interest owned, rather than a Form 1099-DIV, which is received when corporate stock distributes a dividend.

A comparison of an investment in a PTP to an investment in a corporation finds three differences: (1) the annual accounting for the flowthrough tax information on the investor's tax return; (2) the proper adjustment of the basis in the partnership interest; and (3) the complex reporting requirements of the sale of a partnership interest. The flowthrough tax information provided on Schedule K-1 requires annual adjustment to the tax basis of the PTP interest or what is commonly referred to as "outside basis," meaning the partner's basis in the partnership interest. (13) Unlike for stock investments, brokerage firms do not track these basis adjustments, and they are not reflected in the investor's basis in the brokerage account. Instead, the investor must account for these adjustments.

The most common adjustment comes from cash distributions, which reduce the partner's tax basis in the partnership interest. (14) The distributions are commonly, but incorrectly, referred to as dividends in many publications. For example, in the December 2017 issue of Kiplinger's Personal Finance, Blackstone Group reported an annual S2.16 per unit (15) distribution with a Sept. 29,2017, "share price" of S33 that is mistakenly described as a 6.5% dividend yield. (16)

This is in contrast to a corporate distribution from a corporation's earnings and profits, which is a dividend taxable to the shareholder, albeit subject to preferential tax treatment. (17)

For an individual shareholder, qualified dividends are taxed at a favorable maximum tax rate and, for a corporate shareholder, there is a dividend exclusion of at least 50% for dividends from domestic corporations. (18) In general, there is no adjustment to the shareholder's stock basis when a distribution is received. When the stock is sold, the shareholder reports either a capital gain or loss. The sale of a PTP interest is far more complicated because of Sec. 751(a), resulting in the gain being partially treated as ordinary income in certain cases, as discussed below.

For illustrative purposes, this article analyzes the 2016 pro forma Schedule K-1 for the Blackstone Group to illustrate the tax consequences. (19) Table 1 on p. 279 summarizes the flowthrough information found on the Schedule K-1 and its relation to the distribution; Table 2, at right, summarizes the impact on the investor's basis in the partnership interest; Table 3 on p. 282 summarizes the unrelated business taxable income; and Table 4 on p. 282 summarizes the other income including the Subpart F income. The Schedule K-1 reports total net passthrough income of $12,218 and a cash distribution of $16,600 for 2016. (20) The distribution of $16,600 exceeds the passthrough net income by $4,382, resulting in a decrease in the investor's basis in the partnership interest. (21) For calendar year 2016, Blackstone Group made a total cash distribution of $1.66 per unit.

Based on a Dec. 31,2015, market price of $29.24 per unit, the popular press would report the yield as 5.677%. However, this would be an overstatement since a portion of the distribution was a return of tax basis and not income. A better comparison would be to use the per unit net income that passed through, $1.22 per unit, divided by the market price at Dec...