Master limited partnerships are taxed as pass-through entities, which means the partnership itself pays no federal income tax and you, as a unitholder, pick up your share of its income, deductions, and credits each year on a Schedule K-1. Most of the cash you receive along the way is treated as a return of capital rather than a taxable dividend, so it isn’t taxed when it hits your account; instead, it chips away at your cost basis and comes back as ordinary income when you sell. A 20% deduction softens the annual bite, a 3.8% surtax can add to it, and holding units inside a retirement account creates its own tax problem.
You Get a K-1, Not a 1099
Ordinary stock dividends arrive on a Form 1099-DIV. MLP income does not. The partnership files Form 1065 and issues each unitholder a Schedule K-1 showing their fractional share of operating income, capital gains, depreciation, and other items.1Internal Revenue Service. About Form 1065, U.S. Return of Partnership Income You report those line items on your personal return.
Timing matters. Brokerages generally issue 1099s by the end of January, but MLPs typically need until March, and sometimes mid-April, to finalize their K-1s.2Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC (04/2025) If you like to file early, a single MLP can delay your return by months.
There is also a state return problem. MLPs operate pipelines and facilities across multiple states, and because the income flows through to you, each state where the partnership earned money may consider you to have earned income there. Nonresident filing thresholds vary, and more than 20 states require a return for any income earned in the state regardless of amount. The K-1 includes a state-by-state allocation so you can see where you may owe.
Why Your Distributions Aren’t Really “Dividends”
The cash an MLP sends you is rarely a simple taxable distribution. A large portion, often the majority, is classified as a return of capital. Return of capital is not taxable when received. It reduces your adjusted cost basis in the units.
Buy units at $50, collect $5 of return-of-capital distributions over time, and your basis drops to $45. The tax you didn’t pay on that $5 hasn’t disappeared; it’s parked in your lowered basis, waiting for the day you sell. K-1 items from the partnership’s operations can also push your basis up or down, so you need to track it every year.
Basis tracking is the single most important bookkeeping task for MLP investors. Lose track and you risk overpaying on sale or underreporting and triggering penalties. Every K-1 you receive over the life of the investment feeds the calculation.
The Tax Bill When You Sell
Selling MLP units creates two separate layers of tax. The first recaptures all the previously untaxed income represented by your basis reductions. That cumulative amount is taxed as ordinary income at your marginal rate, which reaches 37% for a single filer with taxable income above $640,600 in 2026.3Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 This is the surprise for investors who thought their distributions were tax-free rather than tax-deferred.
The second layer covers any gain above your original purchase price. Bought at $50, sell at $60, and that $10 of true appreciation is taxed at long-term capital gains rates if you held for more than a year.
A worked example makes the split concrete. You buy 100 units at $50 each, for $5,000. Over 10 years you collect $2,000 in return-of-capital distributions, dropping your basis to $3,000. You sell for $6,000. Your total gain is $3,000. Of that, $2,000 is ordinary income recapture (the basis reduction) and $1,000 is long-term capital gain. The $2,000 is taxed at your top marginal rate, not the preferential capital gains rate.
The 20% Qualified Business Income Deduction
Section 199A gives individual taxpayers a deduction equal to 20% of qualified income from publicly traded partnerships.4Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income The deduction was originally scheduled to expire after 2025, but the One Big Beautiful Bill Act made it permanent in July 2025. For MLP investors, it effectively reduces the tax rate on qualifying K-1 income.
The number you need appears in Box 20, Code Z of your Schedule K-1.5Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) You claim the deduction on Form 8995 or Form 8995-A. One advantage specific to MLP investors: the 20% deduction on qualified publicly traded partnership income is not subject to the W-2 wage and capital limitations that reduce or eliminate the deduction for other pass-through businesses. It applies regardless of your income level, though the overall deduction is capped at 20% of your taxable income above net capital gains.
Passive Losses Are Trapped Inside Each MLP
MLP income is treated as passive regardless of how closely you follow the investment, because you’re a limited partner with no operational role. Ordinarily, passive losses can offset passive income from other sources. Publicly traded partnerships get a stricter rule: losses from one MLP can only offset income from that same MLP.6Office of the Law Revision Counsel. 26 U.S. Code 469 – Passive Activity Losses and Credits Limited You cannot net losses from MLP-A against income from MLP-B, from rental real estate, or from any other passive investment.
If the MLP generates a net loss and you have no income from that same partnership to absorb it, the loss suspends and carries forward. It sits there until the MLP produces enough future income to use it, or you dispose of your entire interest. On a complete disposition, all accumulated suspended losses are released and can offset gain and other income on that year’s return.7Internal Revenue Service. Passive Activities – Losses and Credits That makes selling out of a position entirely a different tax event from trimming it.
The 3.8% Net Investment Income Tax
Higher-income investors face an additional 3.8% surtax on net investment income. It applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly.8Internal Revenue Service. Net Investment Income Tax Those thresholds are not indexed for inflation, so more households cross them each year.
MLP income is passive for limited partners, so it falls within net investment income. So does the gain when you sell. Stack the surtax on top of ordinary income recapture at rates up to 37%, and the effective federal rate on an MLP sale can exceed 40% for high earners.
MLPs Inside an IRA: The UBTI Problem
Holding MLP units directly in a traditional IRA, 401(k), or similar tax-advantaged account creates an issue most investors don’t see coming. Because an MLP is an operating business, the income it allocates to a tax-exempt account is unrelated business taxable income. If total UBTI from all sources exceeds $1,000 in a year, the account’s custodian must file Form 990-T and the account itself owes tax on the excess.9Internal Revenue Service. Unrelated Business Income Tax
That tax is computed using estate and trust brackets, which compress fast. For 2026, the 37% rate hits trust income above just $16,000. Even modest UBTI in an IRA gets taxed at rates that would require hundreds of thousands in personal income to trigger. The tax comes out of the account’s assets, which cuts into the point of tax-deferred investing in the first place.
Partnership debt makes it worse. Most MLPs carry significant debt to finance pipelines and storage. Under the debt-financed income rules, a share of the income allocated to a tax-exempt investor is treated as additional UBTI, based on the ratio of partnership debt to asset basis.10Internal Revenue Service. Publication 598 (03/2021), Tax on Unrelated Business Income of Exempt Organizations An MLP that produces relatively little operating income can still push past the $1,000 threshold once debt-financed income is added. Holding individual MLP units directly in a retirement account is generally inadvisable unless you’re ready for the filing and the tax drag.
The Step-Up at Death Erases the Recapture
The most powerful tax feature of MLP ownership shows up only at death. Under IRC Section 1014, heirs receive a stepped-up basis equal to the fair market value of the units on the date of the owner’s death. All of the accumulated ordinary income recapture built up over years of return-of-capital distributions vanishes.
Picture an investor whose basis has been ground down from $50,000 to $12,000. A lifetime sale would trigger $38,000 of ordinary income recapture at rates up to 37%. If the investor instead dies holding the units and they’re worth $55,000, the heirs’ new basis is $55,000. The recapture liability is gone, and the heirs can sell with little or no taxable gain. This is why some long-term MLP investors adopt a hold-and-bequeath approach, collecting tax-deferred distributions throughout life and letting the recapture die with them.
If You Want the Exposure Without the K-1
Several fund structures let you own MLP exposure without ever receiving a K-1 or worrying about UBTI, at the cost of a different tax profile.
Many ETFs, mutual funds, and closed-end funds that hold MLPs are structured as C-corporations, because a fund holding more than 25% of its assets in MLPs cannot qualify as a regulated investment company. The fund pays corporate income tax (21% federally) on its net income before distributing anything to you. You receive a Form 1099-DIV, and UBTI stops being your problem, which makes these funds workable inside a retirement account.11Internal Revenue Service. About Form 1099-DIV, Dividends and Distributions The trade-off is tax drag; the 21% layer bites into returns before you see any of them, and over long holding periods it compounds.
Exchange-traded notes take a different route. An ETN is an unsecured debt instrument issued by a bank that promises to pay a return linked to an MLP index. No K-1, no UBTI, no basis tracking. The catch is credit risk: an ETN is only as reliable as its issuer, and when that issuer fails, so does the note. Lehman Brothers had outstanding ETNs when it collapsed in 2008.