The Trick Is Not Minding

From time to time, we introduce investment vehicles that don’t get a lot of attention from either the pros on Wall Street or the pop market press that so adoringly elevates them in the public consciousness. And when the cool kids do take notice, it’s to point out how “volatile,” “little understood” or “complex” such investments are.

If you’ve followed the Personal finance investment path for the long haul, you’re well aware that one way to growth is to declare independence from Wall Street and the fawning financial media.

Well, we’re at it again. publicly traded partnerships (PTPs) now represent a significant chunk of the Growth portfolio—Enterprise Products Partners, Linn Energy, Tortoise Energy Infrastructure and Tortoise Capital Resources—and TEPPCO Partners brings its high yield to the Income Portfolio.

You’ve probably heard them referred to by a few different names—partnership, limited partnership, LP. And you’ve probably heard the nonsense about how difficult they are come tax time.

You’re not doing your job if you don’t consider the tax ramifications of an investment decision. Nor do you advance your long-term financial goals if you pass up an opportunity because the tax reporting process is a little different or a few steps longer than what you’re used to.

Managing your portfolio is a time-consuming process. You’ve got to do research to find the right mix of investments, you’ve got to find a broker or trading platform to reliably execute your trades, and you’ve got to seek out sources of unvarnished economic and financial news.

If you’ve made it to the back page, and you’re still reading, chances are you’ve identified Personal Finance as a multifaceted resource capable of satisfying some of that. At any rate, you’ve already taken many steps down a long road.

Let’s do it again on the PTP/K-1 issue. It’s not that hard. You’ve put in a lot of work already. And you want to make a decent return.

Because a PTP doesn’t pay tax, it’s able to pass along more of its earnings to its investors than it could if it were in corporate form. It does this through quarterly cash distributions.

Although they resemble corporate dividends, PTP distributions are treated differently—and better—for tax purposes. Rather than taxable investment income, they’re treated as a return of capital and reduce the partner’s basis in his/her partnership units. (The investor’s original basis is the price paid for the units. The basis is adjusted downward with each distribution and allocation of losses and deductions, such as depreciation, and upward 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). Partners won’t be taxed on distributions until: they sell their PTP units and pay tax on their gain, which includes the distributions; or their 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 rate.

Each March, investors receive K-1 tax packages that summarize their allocated share of reportable tax items. In general, cash distributions received during the year shouldn’t be reported as taxable income even though those distributions may appear on your brokerage statement. Only the amounts shown on the K-1 should be entered on your tax return.

Tax consequences to a particular unitholder will depend on the circumstances of the unitholder. Consult your tax professional or financial advisors to determine the federal, state and local tax consequences of ownership of our limited partner units.

You’re not taxed on the distributions you received but rather on your share of the partnership’s taxable income. The excess—the return of capital, if any—will reduce your cost basis in your shares, increasing the capital gain (or reducing the loss) you’ll realize when you sell your partnership units.

The K-1 you’ll receive from your publicly traded partnership is a one-page document setting forth income, gains, losses, deductions and credits of the partnership. Only the amounts shown on the K-1 need to be reported on your tax return.

You don’t file your K-1. That’s the responsibility of the partnership, which generates and distributes them to unitholders. (“Unitholders” are also “partners” within the meaning of the Internal Revenue Code.)

It’s not a lot of information. Many of you probably outsource your tax preparation to a professional, an attorney or accountant specifically trained—and well compensated—to sift through the forms and schedules the IRS and similar state agencies use to track down and extract the lifeblood of government. A tax professional can handle PTP issues easily, and a committed investor can get the job done, too.

But there’s nothing really “easy” about tax forms; there may be more pages, more entries, more signatures, but at the end of the document, you still have to give it up to Uncle Sam. And there’s something uncomfortable about the unfamiliar, but exploration is the story of man.

Neil George and Elliott Gue have prepared a special report on PTPs, which includes a detailed discussion of tax ramifications for individual investors. The report is available at www.pfnewsletter.com/MLP.

The bottom line: Don’t avoid publicly traded partnerships just because you’ll receive a K-1 instead of a 1099.

(by David Dittman is Managing Editor of Personal Finance)

Kamis, 25 September 2008