The trouble with PTPs: These attractive investments can lead to major tax headaches
Get a basic understanding of publicly traded partnerships, and how to spot and plan for potential tax traps
Editor’s note: This article has been reviewed for changes following the passage of the 2017 Tax Cuts and Jobs Act. The information provided in this article was not affected by the 2017 TCJA.
Editor’s note: While this article is not intended to be fully comprehensive, it aims to provide a basic understanding of the structure and tax implications of publicly traded partnerships.
Publicly traded partnerships (PTPs) have become popular investments. That’s because they can provide cash flow with little or no increase in taxable income. They also tend to be in the oil business, sometimes creating lucrative returns for the investor who wants to get into natural resources.
People find PTP investments searching on a stock exchange, or their broker will recommend the investments. But many investors don’t realize they’re buying a PTP. They think they’re buying stock.
Why does that matter? Because PTPs can bring layers of tax complexity to filing a return. They can also create some potentially surprising tax results that investors may not be prepared for. Here, we’ll give an overview of PTPs and highlight some key snags that come up at tax time.
What is a PTP?
At the most basic level, a PTP is a limited partnership with “units” that are traded on a stock exchange.
Structure: General partner and limited partners who own units
A limited partnership has a general partner and limited partners. The general partner is usually a corporation that acts as a sponsor to set up and manage the PTP. The limited partners are investors who purchase PTP units on a stock exchange.
A unit is like a share of stock in a corporation. The owner of the unit, called a limited partner, gets a proportionate share of the partnership’s income. The partner can also receive cash distributions from the PTP.
No entity-level tax
The primary advantage of a PTP structure is that there is no entity-level tax on the partnership. The partners pay tax on their proportionate share of income generated by the PTP.
Limited to certain industries, such as natural resources, private equity and financial services
Section 7704 of the tax code requires PTPs to have “qualifying income.” These qualifying income rules constrain the types of businesses that can be organized as a PTP. Most PTPs operate in the natural resources sector or in private equity and financial services.
How a PTP is similar to a corporation
There are several similarities between corporations and PTPs:
- Much like buying stocks in a corporation, investors can purchase units in a PTP that represent their proportionate ownership of the business.
- Similar to dividends that corporations pay to shareholders, PTPs can pay out distributions to partners.
- Much like shareholders in a corporation, limited partners in a PTP have limited liability, so they are at risk only of losing their investments.
How a PTP is different from a corporation
The similarities begin to diverge at tax time. Here are key differences that impact tax returns:
PTP income goes on the partner’s personal return
Because PTPs are pass-through entities, partners must include their share of the PTP income on their personal tax returns. While some PTPs can generate cash flow with little or no taxable income (as mentioned above), other PTPs can generate high levels of income, leading to potentially large tax liabilities.
This is different from investing in the ordinary shares of a corporation, because shareholders won’t owe tax until they sell their shares at a gain or receive dividends from a corporation.
PTP distributions aren’t taxable -- and reduce tax basis in the investment
Many PTPs also make large distributions to partners. This makes PTPs attractive to people looking for high yields. But unlike ordinary dividends from a public company, PTP distributions are not taxable. Instead, they reduce the partner’s tax basis in the partnership. If a partner receives distributions that are more than his or her basis in the PTP units, the partner will owe tax on the gain.
PTPs keep track of the increases and decreases to basis for each partner. The PTP will include those calculations on a sales worksheet in the Schedule K-1 tax package for the year in which a partner sells his or her PTP units.
Four key tax preparation challenges for the PTP investor
Because a PTP investor is a limited partner rather than a shareholder, the investor needs to account for his or her share of the partnership’s income, credits, and deductions at tax time.
PTP investors will need to be ready to spend additional time (or money) on their tax returns to complete the required forms and schedules to report these items. They’ll also need to diligently track passive losses, and understand the implications of any cancellation of debt income and state-filing requirements.
Here’s more about the four key tax complications on PTP investor returns:
1. Prepare to spend more time on tax prep and compliance.
The Schedule K-1 that reports pass-through income from a PTP investment includes several separately stated income, deduction, and credit items. Some of these credits and deductions are calculated at the partner level. That means each partner may need to prepare additional forms with his or her personal tax return – which can take a lot of time.
The items that commonly take the most time to prepare are:
- The foreign tax credit
- The domestic production activities deduction
- Depletion for natural resources
For example, a taxpayer calculating the foreign tax credit would have to include her distributive share of foreign income and tax in the calculation.
2. Diligently track passive losses for each PTP.
Unless the taxpayer is a general partner or an employee of the PTP, ownership of PTP shares is a passive activity. And like other passive activities, losses are limited to passive income. However, there’s a key difference in passive losses from PTPs: Investors can offset their losses from any one PTP only against passive income from that same PTP – not from other passive activities or other PTPs.
The result: Investors must separately track suspended passive losses for each PTP. This requires more time and effort.
Suspended losses from PTPs become deductible when the partner sells his or her entire interest in the PTP. With declining oil prices, many oil and gas partnerships have been reporting losses and increasing the amount of work required to handle the tax requirements of PTPs.
3. Watch out for cancellation of debt income and the tax bill.
With the recent decline in oil prices, some PTPs have tried to renegotiate their debt. When PTP debt is forgiven or canceled, its partners owe tax on the cancellation of debt income, unless otherwise excluded under the tax code.
PTP investors may be surprised when they are liable for their share of cancellation of debt income. In some cases, this can result in a significant tax liability in relation to the original purchase price of the partnership units.
As with any pass-through income, the tax basis of the partnership units will increase with the recognized cancellation of debt income. This would potentially allow the taxpayer to recover some tax costs through a capital loss or lower capital gain recognized on the eventual sale of the partnership units.
4. Investors may have to file state returns where the PTP operates.
Partnerships that operate in multiple states can generate taxable income in each state. Because PTPs pass through income to their partners, investors may be required to file tax returns in the states where PTPs operate.
Most typical investors don’t make enough income from a PTP to be required to file or pay taxes in states where the partnership generates income. But PTP partners and their advisors should make sure they’re complying with all state tax filing requirements. Review the state schedule included with the Schedule K-1 package, and compare the state schedule to the filing requirements for each state.
Potential solution: Invest in a PTP through a mutual fund or exchange traded fund
Many financial services companies offer mutual funds or exchange traded funds that invest in PTPs. This allows investors to avoid complex tax reporting requirements that can occur with direct PTP investments.
To reduce tax complexity that PTP partners have to handle on an individual level, they may consider investing in PTPs through an IRA account, rather than a traditional taxable brokerage account. However, there is great disagreement in financial planning and tax communities about the wisdom of an IRA owning units in a PTP.
Some say that it’s a good idea, because the PTP distributions generate cash that is added to the IRA balance. In addition, because the income that taxpayers earn in an IRA isn’t taxable, these investment funds effectively “block” the pass-through treatment of income, credits and distributions.*
On the other hand, some people say that this approach defeats the tax benefits of owning a PTP, because nothing that happens in the IRA brings any short-term benefit to the beneficiary’s personal tax returns, and nontaxable distributions from the PTP are taxable when withdrawn from the IRA.
Either way, from a tax standpoint, there is more than meets the eye on PTP investments. As with any investment, taxpayers should consider their investment objectives, risks, and tax implications to make an appropriate investing decision.
* If an IRA earns more than $1,000 of unrelated business taxable income during the year, the IRA may be liable for the resulting tax. Anyone who receives a Schedule K-1 for a PTP that is in an IRA should forward that form to the IRA administrator.