Dividends vs. MLP distributions: What investors should know

Master limited partnerships are starting to announce second-quarter payouts as demand for income-generating investments remains strong. Financial advisers and income-oriented investors are tracking those distributions alongside dividend payments from C-corporations.

C-corporation dividends are paid from corporate profits after the company pays federal and state income taxes. Shareholders then pay tax on the dividend income. Qualified dividends, typically from U.S. firms or certain foreign companies listed on major U.S. exchanges, are taxed at long-term capital gains rates. Nonqualified dividends are taxed at the recipient’s ordinary income rate. Dividends are reported to investors on Form 1099-DIV.

MLP distributions arise from partnerships, most commonly energy midstream firms such as pipeline and storage companies. When at least 90% of a partnership’s gross income comes from qualifying sources, the entity generally does not pay federal income tax. Income, deductions and credits flow through to unitholders instead of being taxed at the entity level.

Unitholders receive an annual Schedule K-1 that shows their share of the partnership’s tax items. Many MLP distributions are treated in part as a return of capital, which reduces an investor’s tax basis in the units. Tax on the deferred portion typically is recognized when the investor sells the units, though any taxable income allocated on the K-1 must be reported in the year it is allocated.

The pass-through treatment can change the timing of tax payments and the paperwork investors must file. K-1s often arrive later in the filing season than 1099s and contain items that can complicate tax returns. Investors may also face state income tax obligations in states where the partnership operates; thresholds for required filings vary by state and by the size of the holding.

Some pass-through income reported on K-1s may qualify for a 20% qualified business income deduction, subject to statutory limits and calculations. The size of the deduction depends on the net income allocated to the unitholder and on the specific tax rules that apply.

Investors evaluating dividend-paying stocks and MLPs compare after-tax cash flow and tax timing. Dividends from C-corporations are generally simpler to report on a 1099-DIV. MLP distributions can result in a higher cash payout and deferred federal tax liability, but they require handling annual K-1s and any state filing requirements.