Master Limited Partnership Depreciation

Depreciation and MLPs

There are a number of characteristics that make master limited partnerships unique.  One such feature is depreciation.  Depreciation is an expense and it is an important expense because master limited partnerships own significant physical assets.  Those assets will depreciate and that has significant accounting consequences.

What is Depreciation?

We know depreciation in our daily lives as the decay or devaluing of a commodity.  For example, when you buy a new car, the moment you drive a new car off the lot that asset will start depreciating.  Why?  The car, as a physical asset that can deteriorate in quality and performance, will be worth less in the eyes of future buyers than what you valued the car when you bought it new.  A new car has more appeal to a car buyer than a used one, all else equal, and so the car’s value depreciates just by the mere fact it was previously owned and certainly depreciates as you drive it, adding wear and tear to the car’s interior and exterior, and worsening the engine and motor performance over time.

Master Limited Partnerships and Depreciation

In accounting, we view the depreciation of a company’s physical assets as an expense, and those expenses can be spread out over the time between when the asset was purchased and when it will have to be replaced. Let’s say you are the CFO of a master limited partnership.

You recently purchased a physical asset, let’s say an oil tanker, and you remember that the government makes an allowance for your company to spread a portion of the costs of oil tankers and other physical assets over multiple years.  If Generally Acceptable Accounting Principles (GAAP) and the Internal Revenue Service (IRS) allow, then you can determine how long that oil tanker will be useful before it needs to be replaced and apportion that cost to replace over the years between when you bought the tanker and when you expect to replace it.  In a simplified calculation, if the oil tanker cost you $100,000 to purchase it and you know it’ll have a useful life of 10 years, then you can claim a $10,000 depreciation expense for the 10 years from when you buy the item to when you are expected to replace it.

Why Depreciation Matters to Unit Holders

Midstream MLPYou might be thinking, “Interesting, but why is a nuance of accounting important to MLPs?”  I wouldn’t be digging into GAAP unless there was good reason and for master limited partnerships there is: MLPs are asset-intensive businesses.  When you’re building a pipeline or drilling for gas, you can expect to purchase a lot of equipment.  You can probably see where this is going; that’s a lot of equipment depreciating and that depreciation expense has a major effect of reducing the MLP’s net income (and reducing the MLP’s tax burden).  Because MLPs are so capital-intensive and because physical assets like pipelines have such a long useful life, the majority of MLP cash distributions to unit holders is tax-deferred.  Pipelines, for example, typically are useful for far longer than their rate of depreciation suggests and that creates a healthy tax benefit for the MLP.

Return of Capital

Unit holders of an MLP benefit from this reduction in taxable income thanks to “return of capital.”  A high percentage of the quarterly distributions to unit holders is treated by the IRS as return of capital, especially in the early years you own the units.   If, like most MLPs, a significant percentage of the unit holder’s distribution is reported to you by the MLP as return of capital, then you only have to pay federal taxes on the portion of the distribution that is not return of capital.  Say, you receive a distribution of $100 every quarter and after all the accounting is completed the MLP informs you that $70 of that distribution is return of capital, then you only pay taxes on that $30 since that is ordinary income.

Other Considerations

As we recently discussed, though, this tax benefit means filing a K-1 instead of the more standard 1099 filing.  The K-1 and the fancy accounting makes some people nervous because they are unfamiliar with the unique tax characteristics of master limited partnerships.  Hopefully this article helped shed some light on this topic, we’ll be covering more related issues involving master limited partnerships in future articles.  As always, be sure to consult your qualified tax or investment adviser on this topic and any others covered in this educational website.



tags: schedule K-1, Master Limited Partnership K-1, MLPs tax, mlps accounting, master limited partnership accounting, accounting master limited partnerships, how master limited partnerships are taxed, depreciation, what is depreciation, depreciation tax, return of capital

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