The Pitfalls of Investing in Master Limited Partnerships
With an increased interest in natural resource investment, many hedge funds have turned towards Master Limited Partnerships (MLP). Generally, these publicly traded vehicles are treated as partnerships for U.S. tax purposes. While focus is often on the economics and distributions, some important tax aspects are often overlooked. These include, but are not limited to the following:
- Passive Activity Losses (PAL)
- Effectively Connected Income (ECI)
- Unrelated Business Taxable Income (UBTI)
- New York City Unincorporated Business Tax (UBT)
An MLP will report on Form K-1 each partner's share of income and deductions. Most MLP's will have passive income or loss among the various other items reported on the K-1. Each MLP investment is treated separately for passive activity purposes. As a result, a specific MLP passive loss can only be offset from future passive income from the same MLP or deducted when the MLP investment is sold. If the MLP reports passive income this cannot be offset by any other passive loss an investor might have from other investments.
Foreign investors in hedge funds structured as a flow through entity are subject to U.S. Federal Income Tax on income "effectively connected" with a U.S. Trade or Business. Most funds avoid passing on effectively connected income (ECI) to their foreign investors under a safe-harbor trading exemption. The ordinary income generated by an investment in a MLP would be not be covered by the safe-harbor rules and would constitute ECI. The fund would need to pay withholding taxes on its foreign partner's distributive share of ECI. In addition, the fund will need to make quarterly estimated ECI tax payments. The receipt of ECI may also cause a foreign investor to file U.S. Income Tax Returns. Gain recognized upon the sale or exchange of an MLP will also be considered ECI, except to the extent that the Fund owns less than 5% of the MLP and that all of the MLP's Assets are considered to be United States Real Property. Offshore hedge funds structured as corporations face similar tax consequences if it invests in an MLP.
Tax-exempt entities are exempt from U.S Federal Income Tax on all income other then income attributable to an unrelated trade or business (UBTI). A tax- exempt partner in a hedge fund structured as a flow through entity must report its allocable share of any income and deductions attributable to the unrelated business activities of a partnership. Most funds generate UBTI by their use of leverage, however the income generated by the MLP would also constitute UBTI for this purpose. Once a tax exempt partner receives UBTI they will be subjected to the filing of Form 990-T and pay taxes on UBTI in excess of $1,000.
Partnerships and individuals that carry on a trade or business in New York City are required to file a New York City Unincorporated Business Tax Return (UBT). New York City assesses a four-percent tax on New York City income. Most funds are exempt from New York City UBT tax under either a full or partial exemption if partnership activities are limited to the purchasing and selling securities for their own account. If an MLP is doing business in New York City the fund at a minimum would be subject to UBT on the MLP's allocable New York City source income. If the position is large enough it could also cause the loss of the partial exemption.
Most MLPs will also cause state filing responsibilities for its partners. Typically an MLP will allocate its income and deductions to the states in which business is carried on. Each partner would then have to file tax returns in those states adding complexity and cost to the fund's tax return. In addition some states require that partnerships withhold tax for non-residents of that state adding additional filing burdens.
Careful consideration on the above issues should be given before investing in MLPs. Many institutions have swap products that will provide the economics of the MLP without the adverse tax consequences.