Mastering Reporting of Publicly Traded Partnership and MLP K-1s on Partners' Returns

Transcription

1 Mastering Reporting of Publicly Traded Partnership and MLP K-1s on Partners' Returns FOR LIVE PROGRAM ONLY TUESDAY, JANUARY 23, 2018, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at ext.1 (or ext. 1). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service x1 (or x1) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

2 Tips for Optimal Quality FOR LIVE PROGRAM ONLY Sound Quality When listening via your computer speakers, please note that the quality of your sound will vary depending on the speed and quality of your internet connection. If the sound quality is not satisfactory, please immediately so we can address the problem.

3 Mastering Reporting of Publicly Traded Partnership and MLP K-1s on Partners' Returns JANUARY 23, 2018 Joseph P. Nicola, Jr., Tax Partner Sisterson & Co., Pittsburgh Tricia Shultz, JD, CPA Sisterson & Co., Pittsburgh

4 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

5 Mastering Reporting of Publicly- Traded Partnership and MLP K-1s on Partners' Returns January 23, 2018 Joseph P. Nicola, Jr., CPA, JD, CVA Tricia M. Shultz, CPA Sisterson & Co., LLP Pittsburgh, PA

6 General Section 7704 Section 7704(a) provides that a publicly traded partnership is treated as a corporation for tax purposes. 6

7 General Section 7704 Section 7704(b) provides that the term publicly traded partnership (PTP) means any partnership if interests in that partnership are traded on: An established securities market, or A secondary market. 7

8 General Section 7704 Section 7704(c)(1) provides that a publicly traded partnership will not be treated as a corporation for tax purposes if the partnership meets the gross income requirements of Section 7704(c)(2) for all taxable years of its existence. 8

9 General Section 7704 Section 7704(c)(2) explains that a partnership meets the gross income requirements for any taxable year if 90 percent or more of the gross income for the taxable year is qualifying income. 9

10 General Section 7704 Section 7704(d)(1)(E) defines qualifying income to include income and gains derived from the exploration, development, mining or production, processing, refining, transportation, or marketing of minerals or natural resources. 10

11 General Section 7704 Income from marketing minerals or natural resources to end users at the retail level is not qualifying income. For example, income from retail marketing with respect to refined petroleum products (e.g., gas station operations) is not treated as qualifying income. S. Rep. No. 445, 100 th Cong., 2d Sess. 424 (1988). 11

12 The Master Limited Partnership A master limited partnership (MLP) generally refers to a PTP that operates an active business, typically in the oil & gas or pipeline industry. 12

13 The Master Limited Partnership Most MLPs are structured in such a way as to satisfy the qualifying income test, thereby resulting in partnership treatment for tax purposes. Throughout the balance of this presentation, we will refer to the MLP as either an MLP, PTP, or a partnership. 13

14 Tax Reform Although not the focus of today s presentation, the recent enactment of the Tax Cuts and Jobs Act affects MLPs. In particular, new Section 199A warrants discussion, since it affects the tax treatment of income passed through by an MLP. 14

15 Tax Reform Section 199A specifically refers to the term publicly traded partnership, so unit holders must take note of the impact. 15

16 Tax Reform - Section 199A Deduction Small Business 20% Deduction. Generally, under new Section 199A, for tax years beginning after 2017 and before 2026, a non-corporate taxpayer which has combined qualified business income (CQBI) from a partnership, S corporation, or sole proprietorship, is allowed a 20% deduction. 16

17 Tax Reform - Section 199A Deduction Special rules apply if the taxpayer receives cooperative or REIT dividends, or has PTP income. 17

18 Tax Reform - Section 199A Deduction If a taxpayer has qualified PTP income, the deduction is equal to the lesser of: (a) Combined qualified business income, or (b) 20% of the excess of the taxable income over net capital gains for the year. 18

19 Tax Reform - Section 199A Deduction Combined qualified business income is: 20% of qualified business income (QBI), as limited by the W-2 limitation, plus 20% of the aggregate amount of the qualified REIT dividends and qualified PTP income of the taxpayer for the taxable year. 19

20 Tax Reform - Section 199A Deduction Under Section 199A, qualified PTP income is the sum of the net amount of the taxpayer s allocable share of each qualified item of income, gain, deduction and loss from a PTP plus any gain recognized by the taxpayer upon the disposition of its interest in the PTP if the amount falls under Section 751(a). 20

21 Tax Reform - Section 199A Deduction Recall that Section 751 converts capital gain to ordinary income to the extent of the partner s share of the partnership s ordinary income assets (i.e., hot assets). 21

22 Tax Reform - Section 199A Deduction QBI is defined in Section 199A(c) as the "ordinary" trade or business income earned from a sole-proprietorship, S corporation, or partnership. QBI does not include, however, any wages earned as an employee. 22

23 Tax Reform - Section 199A Deduction The deduction is available to all taxpayers (except corporations). It is available to estates/trusts. 23

24 Tax Reform - Section 199A Deduction The W-2 limitation is equal to the greater of: 50% of the W-2 wages paid by the business, or 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of its qualified property. 24

25 Tax Reform - Section 199A Deduction Qualified property is defined as tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year. The property must be used at any point during the tax year in the production of qualified business income. The depreciable period of the property must not end before the close of the tax year. 25

26 Tax Reform - Section 199A Deduction Example John, a CPA, earns a $500,000 salary as an employee from his accounting firm. He wants to take advantage of the 20% deduction. 26

27 Tax Reform - Section 199A Deduction Since he cannot do so as an employee, he quits, forms an S corporation, and causes the firm to pay the $500,000 salary to the S corporation. He takes no salary from the S corporation. Result? 27

28 Tax Reform - Section 199A Deduction His 20% deduction will be $-0-. It will be limited to the lesser of (a) 20% of the $500,000 of S corporation pass-through income ($100,000), or (b) 50%/25% of wages paid by the S corporation ($-0-). 28

29 Tax Reform - Section 199A Deduction The W-2 limitation does not apply to everyone. 29

30 Tax Reform - Section 199A Deduction Section 199A(b)(3)(A) provides that if taxable income for the year is less than the "threshold amount" for the year, then the W-2 limitation does not apply. The "threshold amounts" for 2018 are $315,000 for joint filers and $157,500 for all other taxpayers. 30

31 Tax Reform - Section 199A Deduction The W-2 wage limit is phased in for individuals with taxable income exceeding these thresholds, over the next $100,000 of taxable income for joint filers ($50,000 for other individuals). This phase-in is actually referred to as a phaseout. Relief from the W-2 limitation is said to be phased out. 31

32 Tax Reform - Section 199A Deduction Example A has QBI of $200,000 from an S corporation that paid a total of $30,000 of W-2 wages and that has no qualified property. A's spouse earns a salary of $50,000, and A and B have PTP income of $20,000. Thus, joint taxable income is $270,

33 Tax Reform - Section 199A Deduction Normally, the deduction would be $19,000: $15,000, which is lesser of $40,000 (20% of QBI of $200,000), or $15,000 (50% of $30,000 per the W-2 limitation), plus $4,000 (20% of PTP income of $20,000). 33

34 Tax Reform - Section 199A Deduction However, because joint taxable income is $270,000 (i.e., less than $315,000), the W-2 limitation is disregarded, and A simply claims a deduction of $44,000. $40,000 (20% of QBI of $200,000), plus $4,000 (20% of PTP income of $20,000). 34

35 Tax Reform - Section 199A Deduction Another Example A and B are married. A has QBI of $300,000 from an S corporation. A's share of the W-2 wages paid by the S corporation is $40,000. A's share of the unadjusted basis of qualified property held by the S corporation is $0. B earns $55,000 of wages, and A and B have PTP income of $20,000, so that joint taxable income for A and B in 2018 is $375,

36 Tax Reform - Section 199A Deduction Step 1. What would A's deduction have been if taxable income was less than $315,000? It would have simply been 20% of QBI of $300,000, or $60,

37 Tax Reform - Section 199A Deduction Step 2. What would A's deduction have been if the W-2 limitation applied in full? If it applied, A's $60,000 deduction would instead have been $20,000, computed as the greater of: 50% of $40,000, or $20,000, or 25% of $40,000 plus 2.5% of $0, or $10,

38 Tax Reform - Section 199A Deduction Thus, under Step 2, A would have been entitled to a deduction of only $20,

39 Tax Reform - Section 199A Deduction Step 3. Compute the difference between steps 1 and 2. The result is a possible $40,000 reduction to the potential maximum $60,000 deduction under this new provision. 39

40 Tax Reform - Section 199A Deduction Step 4. Compute excess taxable income and apply the phase-out. Taxable income $375,000 Less: threshold ( 315,000) Excess taxable income $ 60,000 40

41 Tax Reform - Section 199A Deduction A s excess taxable income is 60% into the $100,000 phase-out range. Therefore, the potential $40,000 reduction to the deduction will be scaled back accordingly. Potential reduction $40,000 Phase-out percentage 60% Reduction to deduction $24,000 41

42 Tax Reform - Section 199A Deduction A s deduction is equal to 36,000, as follows: Maximum deduction $60,000 Reduction to deduction ( 24,000) Actual deduction $36,000 42

43 Tax Reform - Section 199A Deduction Step 5. Complete the computation of the deduction. A s deduction $36,000 PTP income 20,000 Rate 20% 4,000 Total deduction $40,000 43

44 Schedule K-1 Overview Important considerations: Cover letter. Schedule K-1. Pass-through items and distributions. Supplemental information. Units owned and schedule of units purchased and sold. 44

45 Schedule K-1 Overview 45

46 Schedule K-1 Overview 46

47 Schedule K-1 Overview 47

48 Schedule K-1 Overview 48

49 Schedule K-1 Overview 49

50 Reporting Schedule K-1 Information on a Unit Holder s Form 1040 Several important starting points. The cover letter accompanying Schedule K-1 often contains material information. 50

51 Reporting Schedule K-1 Information on a Unit Holder s Form

52 Reporting Schedule K-1 Information on a Unit Holder s Form

53 Reporting Schedule K-1 Information on a Unit Holder s Form 1040 Unlike more basic pass-through investments, the reportable information is not only found on Page 1, Part III of Schedule K-1, but must also be extracted from the supplemental information statements and/or footnotes. 53

54 Reporting Schedule K-1 Information on a Unit Holder s Form 1040 PTPs are identified in Part I Box D 54

55 Reporting Schedule K-1 Information on a Unit Holder s Form

56

57 Passive Activity Loss Rules and MLPs An MLP will generally be a passive activity for most investors. The passive activity loss rules for MLPs differ from passive activity loss rules for partnerships that are not MLPs. 57

58 Passive Activity Loss Rules and MLPs The general rule under Section 469 provides that passive activity losses may only offset passive activity income, unless the activity is disposed of in a taxable transaction. The general rule permits losses from one passive activity to offset passive activity income of another entity. 58

59 Passive Activity Loss Rules and MLPs In the case of an PTP, however, Section 469(k) provides that the passive activity limitations apply on an PTP-by-PTP basis. Thus, unit holders are required to treat each MLP separately for purposes of calculating passive activity losses. Section 469(k). 59

60 Passive Activity Loss Rules and MLPs The passive activity income from one MLP cannot be used to allow passive activity losses from another MLP or another passive activity. And... 60

61 Passive Activity Loss Rules and MLPs Passive activity losses from one MLP cannot be allowed to offset passive activity income from other MLPs or other passive or nonpassive activities. One exception to this rule: If the entire interest in the MLP is disposed in a fully taxable transaction, losses are deductible and thus may offset other passive and non-passive income. 61

62 Passive Activity Loss Rules and MLPs Note that, unlike non-ptp partnerships, mere disposition of the activities (or subsidiary entities) of an MLP will not constitute a disposition for this purpose. Section 469(k)(3). The unit holder must dispose of all units. 62

63 Passive Activity Loss Rules and MLPs In summary, suspended passive activity losses must be carried forward until either: The MLP has passive income that can be applied to offset its suspended loss, or The unit holder disposes of the entire MLP interest in a fully taxable transaction. 63

64 Passive Activity Loss Rules and MLPs Reporting Example As an example, suppose a unit holder has a suspended passive activity loss carryover from MLP A of $10,

65 Passive Activity Loss Rules and MLPs Reporting Example For the current year (year 1), suppose that her share of MLP A passive activity income is $5,000. Now, suppose that the unit holder also owns MLP B, and her share of current-year (year 1) income from that MLP is $10,

66 Passive Activity Loss Rules and MLPs Reporting Example Her net loss from MLP A is $5,000. This loss cannot be deducted against income from MLP B and is suspended. 66

67 Passive Activity Loss Rules and MLPs Reporting Example MLP A MLP B Suspended loss (10,000) - Year 1 5,000 10,000 Year 1 net income (loss) (5,000) 10,000 Part of M LP A suspended loss used. 67

68 Passive Activity Loss Rules and MLPs Reporting Example Suppose that, in year 2, MLP B reports a loss of $10,000 to the unit holder on her Schedule K-1 and MLP A reports Schedule K-1 income of $10,000 to her. Taxable income from MLP A is $5,000. The entire $10,000 loss from MLP B is suspended. 68

69 Passive Activity Loss Rules and MLPs Reporting Example MLP A MLP B Suspended loss (10,000) - Year 1 5,000 10,000 Year 1 net income (loss) (5,000) 10,000 Part of M LP A suspended loss used. Suspended loss (5,000) - Year 2 10,000 (10,000) M LP B loss cannot be used. Year 2 net income (loss) 5,000 - M LP A suspended loss used. 69

70 Passive Activity Loss Rules and MLPs Reporting Example Finally, in year 3, the unit holder disposes of her entire interest in MLP B in a fully taxable transaction. She has no other income or loss from MLP A or MLP B. The net loss from MLP B of $10,000 is fully deductible. 70

71 Passive Activity Loss Rules and MLPs Reporting Example MLP A MLP B Suspended loss (10,000) - Year 1 5,000 10,000 Year 1 net income (loss) (5,000) 10,000 Part of M LP A suspended loss used. Suspended loss (5,000) - Year 2 10,000 (10,000) M LP B loss cannot be used. Year 2 net income (loss) 5,000 - M LP A suspended loss used. Suspended loss - (10,000) Year Year 3 net income (loss) - (10,000) M LP loss deductible (sold). 71

72 Passive Activity Loss Rules and MLPs How to Report on Form 1040 MLP passive income, gains and losses are not reported on Form Each unit holder must calculate his or her share of income and losses. 72

73 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Unit holders will be required to prepare workpapers that will combine any current year income, gains, and losses, with prior-year suspended losses on a PTP-by-PTP basis. For this purpose, the IRS recommends using Worksheets 5, 6, and 7 of Form

74 Passive Activity Loss Rules and MLPs How to Report on Form 1040 In completing this calculation, the unit holder will include only the same types of income and losses that are included in figuring net income or loss from a non-mlp passive activity. 74

75 Passive Activity Loss Rules and MLPs How to Report on Form 1040 If the result is an overall net gain or income, the result is nonpassive income. 75

76 Passive Activity Loss Rules and MLPs How to Report on Form 1040 The unit holder will report all component items of income, gains and allowed losses from the MLP on the appropriate forms or schedules normally included with Form 1040, and, to the left of each entry space, enter From PTP. 76

77 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example As an example, suppose a unit holder has Schedule E income of $8,000 and a prior-year suspended Form 4797 Section 1231 loss of $3,500 from the passive activities of an MLP. The result is a $4,500 overall gain ($8,000 - $3,500) that is nonpassive income. 77

78 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example On Schedule E, Part II, Line 28, the unit holder will report the $4,500 net gain as nonpassive income in column (j). Column (a) will reflect the name of the MLP and the words From PTP. 78

79 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example In column (g), the unit holder will report the remaining Schedule E gain of $3,500 ($8,000 - $4,500) as passive income. 79

80 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example 80

81 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example On the appropriate line of Form 4797, the unit holder will report the prior-year unallowed loss of $3,500, and enter "From PTP" to the left of the entry space. 81

82 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example 82

83 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Another Example As another example, suppose a unit holder has a Schedule E loss of $24,000 and Form 4797 Section 1231 gain of $14,000 from the passive activities of an MLP. The result is a $10,000 overall loss that is suspended and thus carried forward. 83

84 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Another Example On Schedule E, Part II, Line 28, the unit holder will report the $14,000 loss as a passive activity loss in column (f). 84

85 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Another Example 85

86 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Another Example On the appropriate line of Form 4797, the unit holder will report the gain of $14,000, and enter "From PTP" to the left of the entry space. 86

87 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Another Example 87

88 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities Unlike more basic pass-through activities, MLPs often hold multiple subsidiary entities as assets. The application of the passive activity loss rules to tiered MLPs is unclear. Can the loss of one subsidiary offset the income of another? 88

89 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities In the case of a tiered MLP, it is critical for tax advisers of unit holders to complete the passive activity calculations on a per-activity or persubsidiary basis. 89

90 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities This is so, regardless of the position that the advisor takes regarding the netting of the passive activity income and losses among the activities or subsidiaries. 90

91 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities The practice of completing calculations in the workpapers on a subsidiary-by-subsidiary basis is advisable in the event the IRS takes the position that the passive activity losses of one subsidiary or activity cannot be offset against the passive activity income of another subsidiary/activity. 91

92 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities MLPs holding multiple subsidiaries in their portfolio will provide supplemental information for passive activity purposes. 92

93 Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities MLPs 93

94 Passive Activity Loss Rules and MLPs Tiered Entities and Multiple Activities 94

95 Passive Activity Loss Rules and MLPs Tiered Entities and Multiple Activities 95

96 Passive Activity Loss Rules and MLPs Tiered Entities and Multiple Activities 96

97 Sales of MLP Interests Sales of MLP units are reported on Form 1099-B (reported as the disposition of a traded security). However, due to the treatment of MLPs as partnerships for tax purposes, some component of the sale proceeds will be treated as ordinary income for tax purposes. 97

98 Sales of MLP Interests Schedule K-1 will include a sales worksheet which generally will disclose the portion of the proceeds that must be reported as ordinary income. 98

99 Basis of Units Sold The sales worksheet generally contains the following information: Number of units sold. Acquisition and disposition dates. Adjustments to basis. Ordinary gain component of proceeds. AMT adjustments (reported on Form 6251). 99

100 Sales of MLP Interests Sales Worksheet Disclosure 100

101 Sales Worksheet 101

102 Sales of MLP Interests Form 1099-B Tax advisers and preparers will need to reconcile the data on Form 1099-B with the sales worksheet in order to segregate ordinary income from capital gains. 102

103 Sales of MLP Interests Basis Calculations Unit holders are required to calculate basis using the average basis method (sometimes called the unitary basis method). The unit holder s cost basis for the entire investment is divided by the total number of units to arrive at a basis per unit. Rev. Rul , C.B

104 Sales of MLP Interests Basis Calculations Specific identification and FIFO are not permitted. Cf. PLR (S corporation permitted to specifically identify, though this may have been appropriate to address the impact of the built-in gains tax). The averaging approach runs counter to that which public investors are accustomed. 104

105 Sales of MLP Interests Basis Calculations Suppose A acquired 600 units in an MLP on January 1 for $20 per unit. On June 1, A acquired 700 units in the MLP for $25 per unit. On December 1, A sold 500 units for $30 per unit. Assuming no adjustments to A s basis during the year, A s results are as follows: 105

106 Passive Activity Loss Rules and MLPs Reporting Example Amount realized Units sold 500 Selling price per unit 30 15,000 Basis January 1 June 1 Total Units ,300 Cost per unit Cost 12,000 17,500 29,500 Cost per unit Units sold ,346 Gain 3,

107 Sales of MLP Interests Basis Calculations A unit holder is permitted to use the actual holding period of the units sold. Reg (c)(2). 107

108 Special Considerations for Oil & Gas MLPs Most oil & gas investment vehicles are organized as MLPs due to tax advantages available to oil & gas partnerships. 108

109 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs and Depletion Two tax benefits specific to oil & gas/energy investments are intangible drilling costs (IDCs) and depletion. Each of these presents calculation and reporting challenges. 109

110 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs IDCs are costs that: Are necessary and incidental to the drilling of wells, and Have no salvage value. Regulation Section (a). 110

111 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs IDCs are currently deductible under Section 263(c), and are reported to the unit holders on Schedule K-1 Line 13 Code J. Note, however, that an MLP that holds a working interest (as opposed to a mere royalty interest) may elect to capitalize IDCs (usually as leasehold costs). 111

112 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs In general, such capitalized costs are then deducted over a period of time via depletion. This occurs infrequently. 112

113 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs More frequently, the MLP will treat the IDCs as currently deductible by passing them through on Schedule K-1 Line 13 Code J to each unit holder. The unit holder may, if advantageous, make an annual election to capitalize all or a portion of the IDCs and deduct those costs ratably over a fiveyear period under Section 59(e)(4). 113

114 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs As discussed below, capitalization at the unit holder level should be considered when the unit holder is in an alternative minimum tax (AMT) or a net operating loss position. 114

115 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs If the unit holder elects to capitalize IDCs, the unit holder s share of basis in the property of the MLP according to the MLP s records will differ from the unit holder s share of basis according to the unit holder s records. 115

116 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs This is significant since the MLP may report inaccurate data to the unit holder when the MLP sells the property. 116

117 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Under those circumstances, any unit holder who has chosen to capitalize IDCs will need to exercise caution in computing his or her allocable share of gain or loss. 117

118 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example Suppose X MLP is composed of three equal unit holders, A, B and C. During 2017, X incurred IDCs of $600,000 on January 1. $200,000 is passed through to each unit holder on Schedule K-1 Line 13 Code J. 118

119 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example A and B deduct their shares of IDC, while C elects to capitalize and amortize $150,000 of her $200,000 of IDC. 119

120 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example Based on the foregoing, C will deduct $80,000 of IDCs on her 2017 Form 1040, comprised of $50,000 that she did not elect to capitalize, as well as one-fifth, or $30,000, of the remaining $150,000 that she elected to capitalize and amortize. 120

121 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example IDCs 200,000 Less capitalized portion (150,000) 50,000 Amortization Capitalized IDCs 150,000 Years 5 30,000 80,

122 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example Assume that X sells the property in 2018 for $1.2 million. For 2018, X will provide data to the unit holders on Schedule K-1 Line 11 Code F ( Other Income ) that may be based on an assumption that the unit holder did not capitalize any IDCs. 123

123 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example As such, C s records will indicate that her share of the basis of the disposed property is $120,000 higher than that which is reflected in X s records. 124

124 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example Property Basis MLP Records A B C Unit holder share of property basis at 1/1/ , , , IDC (200,000) (200,000) (200,000) Unit holder share of property basis at 12/31/ Sale A B C Selling Price $1.2 million 400, , ,000 Basis Gain according to the MLP's records 400, , ,

125 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example Property Basis Unit Holder Records A B C Unit holder share of property basis at 1/1/ , , , IDC (200,000) (200,000) (80,000) Unit holder share of property basis at 12/31/ ,000 Sale A B C Selling Price $1.2 million 400, , ,000 Basis - - (120,000) Gain to be reported on Form , , ,

126 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example MLPs should notify their unit holders that they must recalculate their gains and losses if they made an election to capitalize under Section 59(e)(4). 127

127

128 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT As stated above, if the MLP does not capitalize and amortize its IDCs, they can be deducted by the unit holder in the year the expenditures are paid or incurred. 129

129 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT If they are currently deducted, an AMT preference can result. The Section 59(e) capitalization election addressed above serves another purpose. It allows a unit holder to eliminate the AMT preference. 130

130 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT The Section 59(e) election is made by completing the Amortization section of Form 4562 (Depreciation and Amortization). The Code does not require a specific election statement. 131

131 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT The regulations, however, indicate that the election should be made on a statement attached to the unit holder's income tax return (or amended return) for the tax year in which the IDC amortization begins. Reg. Section (b)(1). 132

132 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT If the Section 59(e) election is not made, then the AMT preference must be computed. 133

133 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT The starting point is Section 57(a)(2), which provides that a tax preference item exists to the extent that a taxpayer's excess intangible drilling costs exceed 65 percent of the net income from the property. 134

134 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT Excess intangible drilling costs are defined as the amount by which IDCs exceed the amount which would have been deducted had the costs been capitalized and amortized on a straight-line basis over a 120-month period. 135

135 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT Each unit holder s share of this amount is reported on Schedule K-1 Line 17 Code F. 136

136 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT The next step is to compute the actual amount that will be included in the unit holder s AMT calculation on Form In general, even in the absence of a Section 59(e) election, most individual taxpayers should be able to avoid any adverse AMT impact. 137

137 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT This is due to the fact that Congress enacted a limited exemption for independent producers, including individual investors in partnerships that are independent producers. Section 57(a)(2)(E). 138

138 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT Independent producers are generally defined to include drillers and exploration/production ( upstream ) companies. 139

139 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT The exemption is limited, however, by a computational rule in Section 57(a)(2)(E). The exemption cannot result in a reduction to the unit holder s alternative minimum taxable income (AMTI) by more than 40% of AMTI computed as though the exemption did not exist. 140

140 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Thus, two computations are required. In the first, AMTI is computed as though the full amount of the excess IDCs were required to be included as a tax preference item. 141

141 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Second, the resulting AMTI is multiplied by 40%. The result represents the maximum amount by which the AMTI can be reduced by the exemption. 142

142 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Example Suppose a unit holder s Schedule K-1 reflects $250,000 of IDCs on a well that started producing July 1, Gross income from the property was $60,

143 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Example Lease operating expenses for the property were $20,000. Finally, suppose AMTI before this tax preference is $250,000. The amount of the tax preference would be $219,624, computed as follows: 144

144 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Example Actual IDCs 250,000 Amortization (6 months/120 months) (12,500) Excess IDCs 237,500 Gross income from property 60,000 Lease operating expenses (20,000) Amortization from above (12,500) 27,500 65% of net income from the property 65% 17,875 Tentative tax preference item 219,

145 Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Example AMTI before tax preference 250,000 Tentative IDC preference 219,625 AMTI after tax preference 469,625 Maximum reduction percentage 40% Maximum reduction of IDC preference 187,850 Tentative IDC preference 219,625 Maximum reduction of IDC preference (187,850) Tax preference IDC after the reduction 31,775 AMTI before tax preference 250,000 Form 6251 Tax preference IDC after the reduction 31,775 Line 26 AMTI 281,

146 Special Considerations for Oil & Gas MLPs Depletion The IRS defines depletion as the using up of natural resources by mining, drilling, quarrying stone, or cutting timber. According to the IRS, the depletion deduction allows an owner or operator to account for the reduction of a product's reserves. See Publication 225, Farmer s Tax Guide, Chapter 7, Depreciation, Depletion, and Amortization, p. 46 (IRS 2015). 147

147 Special Considerations for Oil & Gas MLPs Depletion Oil & gas partnerships report depletion annually on each unit holder s Schedule K-1 in proportion with the unit holder s economic interest. 148

148 Special Considerations for Oil & Gas MLPs Depletion The actual amount of the deduction is determined at the unit holder level pursuant to Section 613A(c)(7)(D). In other words, no depletion deduction is claimed at the MLP level. Section 703(a)(2)(F). 149

149 Special Considerations for Oil & Gas MLPs Depletion Taxpayers may elect to utilize either percentage depletion or a cost depletion and deduct the greater of the two calculated numbers. Reg. Section (a). This comparison is completed on a propertyby-property basis. Id. 150

150 Special Considerations for Oil & Gas MLPs Depletion Percentage depletion is calculated based on a percentage, currently 15%, of gross income from the property, but is limited by statute to "taxable income from the property. Section 613(b)(2). 151

151 Special Considerations for Oil & Gas MLPs Depletion Cost depletion is computed by the MLP (more likely by its operating subsidiaries). The computation begins by dividing the leasehold costs of the mineral interest by the estimated recoverable reserves (which results in the cost per unit ). The result is then multiplied by the number of units sold during the tax year. Reg. Section (a). 152

152 Special Considerations for Oil & Gas MLPs Depletion Since the depletion deduction is determined at the unit holder level, the MLP must allocate to each unit holder his or her share of every item that is part of the deduction calculation. Reg. Section 1.613A-3(e). 153

153 Special Considerations for Oil & Gas MLPs Depletion Thus, Schedule K-1 will include a schedule that will reflect each unit holder s share of cost depletion and percentage depletion on a propertyby-property basis. 154

154 Special Considerations for Oil & Gas MLPs Depletion Moreover, each unit holder s Schedule K-1 will reflect his or her share of gross income and net income from each property, as well as the components of net income from each property. 155

155 Special Considerations for Oil & Gas MLPs Depletion Example of an Attachment to Schedule K-1 Representing the Unit Holder s Share of Each Item WELL OIL SALES GAS SALES TOTAL REVENUE OPER EXP DEPR O/H NET INCOME TENTATIVE STATUTORY DEPLETION (15%) COST DEPL GREATER OF COST OR PERCENTAGE DEPL Well A 300, , ,000 (64,000) (17,000) (6,000) 313,000 60,000 62,000 62,000 Well B 200, , ,000 (132,000) (85,000) (16,000) 467, ,000 88, , ,

156 Special Considerations for Oil & Gas MLPs Depletion Note the reference to tentative statutory depletion. This is sometimes referred to as tentative depletion or assumed allowable depletion, which represents the percentage depletion calculated by partnership prior to any comparison to cost depletion. 157

157 Special Considerations for Oil & Gas MLPs Depletion Capital Accounts While depletion is calculated at the unit holder level, it must nonetheless be reflected in each unit holder s capital account. Regulation Section (b)(2)(iv)(k) provides two methods: Simulated depletion Actual depletion. 158

158 Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Regulation Section (b)(2)(iv)(k)(2) provides the rules related to simulated depletion. 159

159 Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Simulated depletion is computed on a propertyby-property basis using either cost or percentage depletion at the MLP level (as demonstrated above), but without consideration of any limitations applicable at the unit holder level, such as the 65%-of-taxable-income limitation discussed below. 160

160 Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Three components should be disclosed in the footnotes and schedules accompanying Schedule K-1: Cost depletion. Percentage depletion (up to property basis) in excess of cost depletion. 161

161 Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Percentage depletion in excess of the basis of property allocated to the unit holder. 162

162 Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Example of the Components WELL TENTATIVE STATUTORY DEPLETION (15%) COST DEPL GREATER OF COST OR PERCENTAGE DEPL PROPERTY BASIS COST DEPL PERCENTAGE DEPLETION UP TO BASIS PERCENTAGE DEPLETION IN EXCESS OF BASIS Well A 60,000 62,000 62,000 62,000 62, Well B 105,000 88, ,000 88,000-88,000 17, ,000 62,000 88,000 17,

163 Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Note that the book capital account of the unit holder may not be equal to the unit holder s tax basis in the MLP interest as a result of this process. 164

164 Special Considerations for Oil & Gas MLPs Depletion Capital Accounts The capital account is reduced by the entire amount of simulated depletion, while tax basis is reduced by depletion to the extent of the unit holder s share of the MLP s basis in the property. Section 705(a)(3). This is part of the reason for the disclosure of the three components of depletion set forth above. 165

165 Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Alternatively, Regulation Section (b)(2)(iv)(k)(3) permits the unit holder s book capital account to be reduced by the unit holder s actual depletion deduction. This method is seldom used, since the MLP seldom has access to individual unit holder records. 166

166 Special Considerations for Oil & Gas MLPs Unit Holder s Depletion Deduction The percentage depletion deduction cannot exceed 65% of the unit holder s taxable income for the year, computed without regard to the depletion allowance or any net operating loss carryovers or carry backs. Section 613A(d)(1). Any disallowed depletion is carried forward to future years. 167

167 Special Considerations for Oil & Gas MLPs Unit Holder s Depletion Deduction Assume a unit holder has 2017 taxable income of $300,000, excluding a depletion deduction as a result of an investment in XYZ Partnership. XYZ owns three properties. Assume further that the unit holder receives Schedule K-1 with the following items related to depletion. 168

168 Special Considerations for Oil & Gas MLPs Unit Holder s Depletion Deduction X Y Z Percentage depletion 180, , ,000 Cost depletion 120,000-30,000 Total tentative depletion 600,000 Taxable income limitation Taxable income 300,000 65% of net income from the property 65% Limitation 195,

169 Special Considerations for Oil & Gas MLPs Unit Holder s Depletion Deduction Allocation of Limitation X Y Z Total Percentage depletion 180, , , ,000 Percentage depletion as limited* 58,500 87,750 48, ,000 Cost depletion** 120,000-30,000 Percentage depletion as re-limited*** - 125,357 69, ,000 Depletion deduction greater of cost or percentage depletion 120, ,357 69, ,000 * Allocated in proportion to tentative percentage depletion. ** Cost depletion is compared to percentage depletion, as limited. *** Since cost depletion exceeds percentage depletion on Property X, the taxable income limitation is re-allocated between Properties Y and Z. 170

170 Special Considerations for Oil & Gas MLPs Depletion Impact on Basis in MLP Interest As suggested above, depletion is not deducted at the MLP level. As such, depletion as computed by the MLP cannot reduce the basis of a unit holder s interest under the general basis rules. 171

171 Special Considerations for Oil & Gas MLPs Depletion Impact on Basis in MLP Interest Rather, as stated above, Section 705(a)(3) requires the reduction of the basis of each unit holder s interest by the amount of his or her oil and gas depletion deduction to the extent the deduction does not exceed the unit holder s share of the MLP's basis in the property. 172

172 Special Considerations for Oil & Gas MLPs MLP Sale of Depletable Property When the partnership sells the underlying property, then the capital accounts of the unit holders must be adjusted by the simulated gain or loss, assuming that the capital accounts were previously adjusted by simulated depletion. 173

173 Special Considerations for Oil & Gas MLPs MLP Sale of Depletable Property In completing this computation, the MLP will determine gain or loss by reference to simulated net book value, which, in turn, is determined after subtracting simulated depletion. 174

174 Special Considerations for Oil & Gas MLPs MLP Sale of Depletable Property As with the reporting of depletion, tax gain or loss from the disposition of oil & gas properties is not reported as part of the data reported on the face of Schedule K

175 Special Considerations for Oil & Gas MLPs MLP Sale of Depletable Property Rather, when an MLP sells or disposes of an oil and gas property, the MLP does not compute the tax gain on the property. 176

176 Special Considerations for Oil & Gas MLPs MLP Sale of Depletable Property The MLP is required to allocate the amount realized from the sale to each unit holder and each unit holder uses his or her individual tax basis in the property to compute gain or loss on the sale. Section 613A(c)(7)(D). 177