Tax Structure of Master Limited Partnerships – How it Can Benefit MLP Unit-Holders

A master limited partnership (MLP) is a unique investment that combines the tax advantage of a limited partnership with the liquidity of a publicly traded stock, allowing stockholders quickly to buy or sell their stocks. MLPs issue investment units that are traded on a security exchange exactly like shares of any other stock. To qualify as a MLP, a company must generate at least 90% of its income from operations in the real estate, financial services, or natural resources sectors.

The major reason for a company to go into a business structured as a MLP is the tax avoidance. Unlike corporations, master limited partnerships are not subject to double taxation (paying taxes at both corporate and personal levels). The owners of the partnership are taxed only once on their individual portions of the MLP’s income, gains, losses and deductions. On quarterly basis, MLPs make distributions that are similar to dividends to its unit-holders. Unlike dividends, these distributions are not taxed when they are received because they are considered return of principal. That results in higher yield, because the money that would have been paid for income taxes are distributed to investors. Furthermore, the tax law allows companies to amortize or depreciate money that is invested in an asset. MLPs allow those deductions to pass through to the unit-holder, who pays no taxes until decides to sell the investment. At the selling point, the investor has to pay taxes over the realized capital gains (the difference between the sales price and the initial cost). The capital gains are taxed at a lower tax rate and the unit-holders end up paying less overall in taxes than they would if it were considered interest instead.

MLPs contain two business entities: general partners and limited partners. General partners manage the day-to-day operations of the MLP, while limited partners have no involvement in the company’s operation activities but investing capital and obtaining periodic cash distributions in return. Generally, the general partners receive 2% of the whole partnership pie and they have the right to own limited-partner units to increase its ownership percentage. A distinguishing characteristic of MLP is the incentive distributions rights (IDRs). Considering the fact that company performance is measured by the cash distributions to the limited partners, IDRs provide the general partners with a performance- based pay for successfully managing the master limited partnership. The IDRs are structured in such way that for each incremental dollar in cash distribution, the general partners receive higher marginal IDR payments, which can increase the initial 2% distributable cash to higher levels such as 15%, 25% up to 50%.

The fact that master limited partnerships pay no federal and state income tax means that more cash is available for distributions. This makes MLP units worth much more than similar shares of corporation. The value of MLP’s units is determined by the distributable cash flow. Therefore, the majority of MLPs operate in very stable, slow-growing sectors of the energy industry, such as pipelines and storage terminals. These assets produce steady cash flows with little variations that allow the MLP to meet its cash distribution requirements.

How Are LLCs Taxed?

Before considering any type of business entity, you’ll want to consider the pros and cons of each structure and what will work best for your business. One of the first questions that new business owners ask is this one: “How will my business be taxed?” For small business owners who choose to form an LLC structure, there are several options to consider.

Knowing the facts before considering the tax structure for your Limited Liability Company will keep you out of hot water. There are several options to consider. You may be taxed as a partnership or sole proprietorship, taxed as an S corporation, or taxed as a C corporation:

An LLC is usually taxed as a sole proprietorship or partnership. Under normal circumstances, the LLC is taxed as a partnership or sole proprietorship. In 1997, the IRS established federal default rules. The default rules say, if you have one owner, the LLC will be taxed as a disregarded entity, meaning all the profits and losses will show up on your personal tax return (if you are the owner). In this case there is no federal or state single member LLC that is disregarded for tax purposes.

If the LLC has two members, the default is to be taxed as a partnership. That means a 1065 is filed on April 15th federally each year. If you business is earning earned income all the profits are subject to self employment taxes in 2009 which is up to $106,800. If it is taxed as a partnership and one partner is not active (they work very few hours or are just passive) their distributions may not be subject to self employment taxes. Be sure to check with your CPA for exact input. For the one-owner LLC, you’ll file a 1040 tax return and attach a Schedule C.

As a Limited Liability Company taxes as a partnership, you’ll pay no federal income taxes when taxed in this manner. The LLC is often called a “pass through” entity. This means that each member (owner) of the LLC reports his or her share of the profits and losses on their individual tax returns, regardless of the number of members. LLCs with multiple members will report their individual profits and losses on Schedule C as well.

An owner may elect to S corporation tax status. Many LLC owners opt to elect S Corporation tax status because they can pay themselves a reasonable salary, tax that amount, and collect distributions from the company as surplus income. This often results in a substantial savings to the owners. First, the key is to file the federal 2553 certified to the IRS.

The EIN application is not enough to tell the IRS your entity is taxed as an S election. Plus you may have a home state form to file, make sure you check! For instance, an LLC owner that earns $60,000 and is taxed as a sole proprietorship will pay $9,180 in self-employment taxes ($60,000 X 15.3%=$9,180). If you elect an S Corporation tax status, you may choose to pay yourself a salary of $40,000 (a reasonable salary is required). That salary will be taxed at the same 15.3% rate, but you’ll save $3060 in taxes. You can then pay the remaining $20,000 as a distribution from the company.

What happens when an LLC elects corporation (C corporation) tax status? If you decide to structure your LLC as a corporation, you will need to file form 8832 to the IRS. Plus you will need to amend or update the operating agreement to note the language about the C corporation election.

You will pay federal income taxes on the profits if the LLC is taxed as a C corporation. At first, this may not seem like good business sense, but if you plan to expand the business one day and would like to leave the profits in the business, you could save on taxes in the long run. To benefit from this structure, the LLC should be generating profits since the first $75,000 is taxed at a lower rate than a sole proprietorship or partnership.

Tax laws can be confusing. When you form an LLC, consult a tax professional to help you decided which tax structure will work best for you. Since tax laws change from year to year, don’t leave your decision up to chance. What you don’t know may significantly hurt your bottom line.

Taxing the Internet – Legislation That May Result in a New Tax Structure in Every State of the Union

Historically, when software was first being written in the period circa 1960’s – 1980’s, it was thought of as intellectual property. It was classified as such because it was a creation of the human mind, committed to something called source code. During this period there were very few computer languages available to write source code in and among the favorite were FORTRAN, Assembler, Basic and C. Of course, there was the nearly impossible language called machine language that really preceded all the rest. These languages were the tools one used to create a computer program.

As things were developing in software, meaning complete programs written that could do one or more tasks on the computer (actually a microprocessor), there was a major move initiated by a governor in the State of Illinois that would tax such intellectual property. Although the matter was fought in court, the State of Illinois won. It is because of this event that all software you purchase is taxed.

The Quill Corporation fought all the way to the Supreme Court, their being forced to charge a State of Illinois tax on products they sold out of state. They won and technically, if you pay a tax on something from an out of state store, as one would find on the internet, that store must have an agent in the state you reside before the local state tax can be added.

This new classification of what was intellectual property, as described in copyright laws, started in one state and then quickly was expanded to all 50 states. It was a new cash-cow for government.

We are now at the brink of another tax that if passed, could be quickly applied throughout all other states. The legislation is introduced by the 14th District State Representative, Nancy Skinner. In it, she wants to tax sales over the internet. It does not seem to matter what kind of sales, just sales in the State of California purchased over the internet.

This is a dangerous piece of legislation for everyone who uses the internet because just like the taxation of intellectual property that expanded throughout the entire 50 states, so too will Skinner’s legislation be adapted by other states as well.

You can read Skinner’s legislative proposal by clicking on this link.

Recommend course of action: Write to Skinner even if you do not live in her Representative District and make her aware of how her bill could potentially adversely affect all sales over the internet.