Cash Distributions (vs. Income)
A second critical concept in understanding the impact of the ETF/corporation structure on the MLP investment thesis is the difference between distributions and income. In the case of MLPs, these are entirely different things.
When an MLP distributes cash back to its investors, that cash distribution is always treated as a “return of capital” for tax purposes. These distributions are not taxed when received, but instead lower the cost basis of the position (and thus will be taxed at some later date when the security is sold). Again, this tax deferral is one of the major benefits to investing in MLPs. Any distributions from the MLP always adjust downward the investor’s (in this case, the ETF/corporation’s) basis in that MLP.
However, that doesn’t mean the MLP position is entirely tax deferred. Shareholders of a partnership are liable for taxes on the income of that partnership, regardless of whether any cash distributions are made. So when someone says that “80% of XYZ MLP’s distributions are tax deferred,” what they really mean is that the taxable income presented on the partnership’s K-1 was equal to 20% of the nontaxable cash distributions. The investor’s share (in this case, the corporation’s share) of taxable partnership income each year adjusts its basis upward in that MLP.
Accelerated Depreciation and the 754 Election
There’s one last thing that will impact the tax basis as well: depreciation.
Depreciation is an accounting measurement that matches the price paid for equipment to the year the equipment was actually used. Many capital expenditures are paid for up front, but the equipment is used over multiple years. Depreciation spreads this cost over the years of use—changing the yearly income recognized. Accelerated depreciation—which was implemented to encourage capital investments—allows for more charges to be recognized in the early years of equipment use, decreasing taxable income in the early years and increasing taxable income in the later years of the equipment’s life. Most MLP equipment is depreciated using a 15-year accelerated depreciation schedule.
The partnership has its own way of handling these types of depreciation. Within the tax code, a Section 754 election allows purchasers of a partnership to use the amount paid for the basis in the partnership interest, and for accelerated depreciation to be calculated off the time the security was held by the investor—not how long the equipment has been held by the MLP. This is another flexibility afforded to owners of individual MLPs.
For the MLP ETF, however, this means the depreciation schedule is set every time the fund buys an MLP, and reset every time the fund sells and buys back the same MLP. If the fund is run properly, shares with longer time horizons can be sold for redemptions and bought back for creations. This simple act front-loads accelerated depreciation. Continuing to reset the depreciation will make it more likely the fund continues to pay return-of-capital distributions, aiding the fund’s tax efficiency. In addition, most MLP general partners are aware that investors want tax-deferred income and make purchases to create more depreciation charges. To summarize: The investor’s share (in this case, the corporation’s share) of depreciation adjusts its basis downward in that MLP.
Actually Paying Capital Gains: Ordinary Income Recapture
When an individual MLP is sold, the entire difference between the share price of the MLP and the cost basis is not taxed at capital gains rates. Instead, the portion of the gain resulting from cost-basis reductions stemming from depreciation is taxed at ordinary income rates. This is termed “recapture.” The gain attributable to your share of some types of assets held by the MLP—substantially appreciated inventory and unrealized receivables—is also taxed as ordinary income. The IRS instituted this rule to keep investors from recognizing substantial depreciation charges in an attempt to minimize ordinary income and maximize capital gains. It is important to mention, however, that there is no income recapture at the fund level, so any difference between the reduced basis and the sale price is taxed as a capital gain (assuming it is held for more than a year).