Two weeks ago, we attended the National Association of Publicly Traded Partnerships’ (NAPTP) annual investor conference in Stamford, Conn. We shared our biggest takeaways from the event in the most recent issue, Growing Pains: MLPs Go Mainstream.

However, we didn’t touch on one subject that’s near and dear to the hearts of every investor who holds master limited partnerships (MLP) in his or her portfolio: taxes. 

At one point during the panel discussion on MLP tax issues, I looked up from taking notes to take in what had to be the biggest crowd of any event at the conference. Regardless of whether they were sitting or standing, almost everyone in the cavernous presentation hall had the look you see most often in a dentist’s waiting room. Everyone knew they had to attend the panel but dreaded the prospect.

In addition to arcana, the panelists tackled the one question on all attendees’ minds: Will the federal government change MLPs’ tax treatment? The professionals approached this subject with characteristic caginess and a number of qualifiers but noted that the near-term outlook appears sanguine. To justify their outlook, the panelists cited the jobs created by the US energy sector, the unpopularity of such a move with individual investors, and pending legislation that would allow renewable-energy outfits to structure themselves as MLPs.

Regardless of the legislative risk to MLPs, investors can take some simple steps to gird their portfolios against adverse federal action–or any other black swan.

• Rule No. 1: Your portfolio’s allocation to MLPs shouldn’t exceed more than 25 percent of your investable assets. Investors who bulked up on Canadian royalty trusts before the government announced changes to the group’s tax status can attest to the wisdom of this rule.
   
• Rule No. 2: Stick with names that can still thrive even if they’re taxed at the corporate level. Consider what happened after Canada amended its tax treatment of royalty trusts: Not one midstream name that converted to a corporation cut its dividend, thanks to their robust growth opportunities and remaining tax advantages. We would expect most pipeline-owning MLPs to hold their own if Congress were to repeal the structure’s tax advantages. Investors should focus on names with lower debt loads, secure revenue streams and elevated distribution coverage.
   
• Rule No. 3: Commit yourself to maintaining a balanced, diversified portfolio. Never allow a single holding to grow out of proportion to the rest of your portfolio. And don’t be afraid to take some money off the table in your biggest winners. Having a store of dry powder on hand for opportunistic stock purchases is always a good idea. With investors piling into MLPs and other groups that offer above-average yields, overpaying for income is a real risk.

K-1 Fun

For many investors, dealing with the unfamiliar Schedule K-1 instead of the usual Form 1099 is a real headache.

But MLPs have worked closely with KPMG and other big accounting firms to simplify the process for do-it-yourself filers to cruise through the process using Turbo Tax and other popular software programs. The industry is also making progress disseminating tax material to investors well in advance of April 15.

The best source for K-1 information is usually the websites of the MLPs you own. Enterprise Products Partners LP’s (NYSE: EPD) site, for example, includes a tax information page that enables users to enroll in electronic K-1 delivery and obtain personal tax schedules–among other options. Alternatively, you can find links to the online tax packages for most publicly traded partnerships at the Tax Package Support website.

For general information on this thorny subject, the NAPTP’s website covers the basic terms and concepts associated with MLP taxation. Here’s a refresher course.

MLPs pass through the majority of their profits, losses and deductions to unitholders who pay personal income taxes on their share of taxable profits. In this way, MLPs investors avoid the double taxation to which corporate dividends are subject.

The distributions paid by MLPs are credited directly to your brokerage account. Unlike a regular dividend, the IRS considers these distributions a return of capital that reduces your cost basis in the MLP but isn’t taxed until you sell your position. At that point, the taxable amount is the difference between your cost basis and the price at sale. The majority of this amount is generally taxed at capital-gains rates.

The portion attributed to “depreciation” and “substantially appreciated inventory and unrealized receivables” is taxed at your ordinary income rate. Starting this year, that tax rate is elevated by the 3.8 percent surcharge for “investment income” as part of the 2010 Health Care Reform Act.

The NAPTP’s website also includes an extensive section on holding MLPs in tax-deferred retirement accounts.

Some of the net income that MLPs allocate to their unitholders is classified as unrelated business taxable income (UBTI). Each taxpayer has a $1,000 total annual allowance for UBTI paid into a 401(k) or IRA account; levels over this threshold could incur a tax liability. 

As many MLPs actually generate negative UBTI, the possibility of reaching $1,000 is actually quite remote–unless the investor holds literally tens of thousands of units of high-UBTI MLPs. And even in the worst case, any tax due on UBTI would be rather negligible.

Investors who hold MLP units in an IRA account don’t need to monkey with a Schedule K-1. Rather, the custodian will file a Form 990-T summarizing the account and any UBTI. And if you owe any tax on UBTI, it’s the custodian’s responsibility to pay it out of your account.

In our view, the real drawback of holding an MLP in a tax-advantaged account is the opportunity cost: When you withdraw funds from an IRA, you pay taxes at your regular rate, not the MLP’s tax-advantaged rate.

We’d argue that the fat returns offered by MLPs are worth the added hassles at tax time. We’re encouraged, however, that the industry is still working hard to make things easier for investors.

There are also alternatives for investing in MLPs that involve no K-1 filings or tax complications of any sort. These include closed-end funds such as Kayne Anderson Energy Total Return (NYSE: KYE), which currently trades at a relatively modest premium of 4.3 percent to net asset value and yields about 6.8 percent.

Several MLPs also offer alternatives to their common units that don’t require investors to deal with a schedule K-1.

To expand their shareholder bases and improve liquidity, Kinder Morgan Energy Partners LP (NYSE: KMP) and Enbridge Energy Partners LP (NYSE: EEP) created I-shares, an alternative unit class that offer exposure to the same underlying assets but replace the MLP’s quarterly cash distribution with an equivalent number of I-shares. These “paid-in-kind” distributions aren’t subject to tax until the holder sells his, hers or its position, at which point the capital gains rate would apply.

Likewise, LinnCo LLC (NSDQ: LNCO), which raised about $1.1 billion when it went public on Oct. 12, 2012, owns a 13.2 percent equity stake in its parent company, upstream operator Linn Energy LLC (NSDQ: LINE). Each share of LinnCo represents one unit of Linn Energy and its qualified dividends mirror its parent’s quarterly distributions. LinnCo provides exposure to Linn Energy’s growth story and enticing yield without the tax headaches.

Marine-transport providers Navios Maritime Partners LP (NYSE: NMM) and Capital Products Partners LP (NSDQ: CPLP) are also structured in such a way as to avoid K-1 filings.

A word of warning is in order: Investors’ top priority should never be tax avoidance. Always focus on names that are well-positioned to grow their underlying business and generate superior total returns. Even if you limit your tax burden, a dividend isn’t worth much if the company can’t at least maintain its quarterly payout.