Publicly Traded Partnerships: What they are and how they work
What is a publicly traded partnership?
publicly traded partnership (PTP; also known as a master limited
partnership, or MLP) is exactly what its name suggests: a limited
partnership the interests in which (known as "units")
are traded on public exchanges, just like corporate stock.
limited partnership has one or more general partners (they may be
individuals, corporations, or other partnerships) which manage the
partnership, and limited partners, which
provide capital to the partnership but have no role in its
management. When an investor buys units in a PTP, he or she becomes
a limited partner.
are formed in several ways. A nontraded partnership may decide to go
public. Several nontraded
partnerships may "roll
up" into a single PTP. A
corporation may spin off a group of assets or part of its business into
a PTP of which it is the general partner, either to realize the assets' full
value on the marketplace or as an alternative to debt.
A corporation may fully convert to a PTP, although since 1986 the
tax consequences have made this an unappealing option for most.
Or, a newly formed company may operate as a PTP from its
companies can be PTPs?
added to the tax code in 1987 require any partnership that is publicly
traded to receive 90 percent of its income from specified sources.
A PTP not meeting
this test will be treated as a corporation for tax purposes (see below).
income for PTPs includes interest, dividends, real estate rents, gain
from the sale or disposition of real property, income and gain from
commodities or commodity futures, and income and gain from mineral or
natural resources activities. Mineral
or natural resources activities include exploration, development,
production, mining, refining (including fertilizers), marketing and
transportation (including pipelines), of oil and gas, minerals,
geothermal energy, or timber. This means that most PTPs today are in
energy, timber, or real estate related (including mortgage securities)
the time the 1987 rules were enacted, there were some PTPs already trading
that did not have the right kind of income.
These PTPs (known as the "grandfathered"
PTPs) were given a transition period of ten years, until December 31, 1997,
before they would have to either meet the test or be taxed as
corporations. The Taxpayer Relief Act of 1997 extended this transition rule
indefinitely for grandfathered PTPs electing to pay a small (3.5 percent)
tax on their gross income from partnership business activities.
About a dozen PTPs made this election; five are still trading.
a list of currently trading PTPs, click here.
is the difference between a PTP and a corporation?
corporation is a distinct legal entity, separate from its shareholders and
employees. The corporate
entity carries the liability for all the obligations of the corporation;
the shareholders contribute capital but have no liability to business
creditors, tax authorities, litigants, or any of the numerous other
parties which may have a claim on corporate earnings and assets.
corporation is treated as a separate entity for tax purposes as well.
Like individual taxpayers, it must pay a tax on its income.
After taxes are paid, some corporate income is retained at the
corporate level and used for capital investment and other purposes.
Some is passed through to shareholders in the form of dividends,
and the shareholders pay tax on the dividends they receive.
For this reason, it is said that corporate income is
"double-taxed," or taxed at two levels.
PTP, as a partnership, is not considered to be a separate entity, but rather
is an aggregate of all the partners. All partners are liable for the
obligations of the partnership; although
limited partners enjoy limits on their liability, they are not fully
shielded in the way shareholders are.
Creditors generally have the right to seek return of capital
distributed to a limited partner if the liability for which payment is
sought arose before the distribution.
This right survives the
termination of a partner's interest. Limited
partners may also be liable for substantial tax liabilities that could be
determined through the audit process long after they have sold their
interest. As a practical matter, however, this is unlikely to happen
to a PTP investor.
partnership is referred to for tax purposes as a "pass-through" entity.
No tax is paid at the partnership level. A partnership's income is considered earned by all the partners;
it is allocated among all the partners in proportion to their interests in
the partnership, and each partner pays tax on his or her share of the partnership
income. All the other items
that go into determining taxable income and tax owed are passed through to
the partners as well--capital gains and losses, deductions, credits, etc.
Partnership income is thus said to be "single-taxed,"
or taxed only at one level--that of the individual partner.
does this mean for PTP investors?
Because the PTP itself does not pay tax, it is able to pass along more of its earnings to its investors than it could if it were in corporate form. It does this in the form of quarterly cash distributions. Although they resemble corporate dividends, PTP distributions are treated differently, and better, for tax purposes. Rather than taxable investment income, they are treated as a return of capital and reduce the partner's basis in his partnership units. [The investor's original basis is the price paid for the units. The basis is adjusted downwards with each distribution and allocation of deductions (such as depreciation) and losses, and upwards with each allocation of income.]
When the units are sold, the difference between the sales price
and the adjusted basis equals taxable gain (or loss). The partner will not be taxed on distributions
until 1) he sells his PTP
units and pays tax on his gain, which includes the distributions; or
2) his basis reaches zero.
Some of the tax on the capital gain from selling the interest will
be paid at the capital gains rate. That portion of the gain
that results from a downward adjustment of the basis after allocation of
depreciation or other deductions will be taxed at the ordinary income
tax filing season a PTP investor will receive a K-1 form showing his share
of each item of partnership income, gain, loss, deductions, and credits.
He will use that information to figure his taxable partnership
income (PTPs provide their investors with material that walks them through
all the steps). If the
result is net income, the partner pays tax on it at his individual tax
rate. If the result is a net
loss, it is considered a “passive loss” under the tax code and may not
be used to offset income from other sources, but must be carried forward
and offset against future income from the same PTP.
is important to note that a PTP investor is taxed on his share of
partnership income whether or not he actually receives any cash from the
partnership. His tax is based not on money he actually receives, but his
proportionate share of what the partnership earns. However, most PTPs make it a policy to make quarterly
distributions to their partners that will comfortably exceed any tax owed.
about institutional investors?
An important aspect of corporate vs. pass-through taxation is the way tax-exempt investors, such as IRAs and pension funds, are treated. Tax-exempt entities are subject to "unrelated business income tax" (UBIT) on income they earn from business activities unrelated to their exempt purpose. If a tax-exempt entity invests in a PTP, it will, like any partner, be considered to have "earned" its share of the partnership's business income as if it were directly involved in the business. If that income is not one of the types that are exempted from UBIT (interest, rent, royalties, and dividends) the exempt organization will have to pay tax on its share of PTP income. This makes it much more difficult for PTPs to attract institutional investors than it is for corporations (note, however, that the first $1,000 of unrelated business income is not taxed, which may make it possible for a small holder such as an IRA to hold PTP units).
In addition, under the tax code, mutual funds must receive 90 percent of their income from qualifying sources such as interest and dividends. Distributions and allocated income from a PTP will usually be nonqualifying. This limits the extent to which mutual funds have invested in PTPs. The Coalition of Publicly Traded Partnerships currently is advocating legislation that would make PTPs a fully qualifying income source for mutual funds.
does an LLC fit into this picture?
limited liability company, or LLC, is a hybrid between the corporate and
the partnership form that has been developed over the past several years. Investors in LLCs enjoy the limited liability associated with
corporations, combined with the passthrough tax treatment of partnerships.
The Internal Revenue Service and state tax authorities have specifically ruled that properly
structured LLCs will be treated as partnerships for tax purposes.
LLC interests may be (and in some cases are) traded on public
exchanges. When that is
the case, an LLC is in effect a PTP, and is subject to the PTP rules of
the tax code.
The Coalition of Publicly Traded Partnerships is a trade association representing publicly traded partnerships, their general partners, and those who work with them. We are neither tax nor investment advisors and should not be relied upon as such. For further information, call Mary Lyman at 202-454-6624; or send an email to [email protected]nsulting.com .