My accountant said
One partnership (Linn Energy) had large basis adjustments and ordinary income adjustments causing Federal tax to now increase quite a bit.
Has anyone else noticed this or is my accountant wrong
The basis cannot be negative. Anything below zero results in a tax at LTCG rates. The maximum tax would be 35% + your state tax plus LTCG of 15% on whatever portion of the basis was negative. Again you would have had to own for several years to get there!
As I said, for my MWE shares, I think I'll reach 0 cost basis soon...in only 4 years(?) since I got them so cheap. I'm receiving distributions at a rate of almost 25%, so it should be about 4 years (since there is almost no income to report, which would raise the basis back up... Is there any way to know how close you are to a 0 basis? I'd like to sell some shares and would like to know the consequences ahead of time. Are there numbers that I need to get from the MLP? Or do I already have everything I need?
Well if you can have a basis adjustment that results in negative basis, then that would negate PSHONORE's proposal that "Considering that the top tax rate is 35%, how could taxes ever take more than 35% of sale proceeds?"
If basis can be arbitrarily negative then taxes could be unlimited (in theory).
Not really sure about this, just mulling it over.
Everyone's K1 can be different but for me, IDCs and depletion for EVEP just about offset the Box 1 income. Hopefully you're accounting for the IDCs and depletion on an annual basis as they are a deduction against income.
Doubt MWE would have much if any depletion as it is usually only a factor in direct O&G production/drilling like LINE, EVEP, VNR, etc (KMP has a small amount of IDCs though)
I'm not sure about my Linn shares, but I bought my Markwest shares so cheap that it looks like I'll be close to a zero basis in only 4 years (next year?). I don't know about depletion. But it will further lower my basis. I guess they tell you that number after you sell? Maybe you can ask ahead of time?
But my EVEP shares have been reporting taxable income (line 1)...enough to keep pushing the basis up by about the same as the distributions each year.
Distributions are RETURN OF CAPITAL. They are tax free simply because you are just getting some of your initial investment returned to you. It’s like buying 100 shares of any stock and then selling 4 shares at cost. There is no tax.
The difference is that in an MLP, your number of units doesn’t reduce. Instead, your cost basis in the units is reduced. As a result, when you ultimately sell your units you pay capital gains on the proceeds after adjusting the cost basis downward.
For instance, if you invested $10,000 and received $4,000 in tax free distributions over the years your cost basis is now $6,000. If you sell the remaining units for $8,000 (what you perceive as a loss), you will actually incur a capital gains tax on $2,000.
The MLP is also able to make capital distributions because it has earned income to sustain them (if not, the MLP is on its way to ZERO). Normally this earned income would be fully taxable to the unit-holder. However, the MLP has various tax offsets such as depreciation, depletion allowances, etc. that reduce or eliminate current income taxation.
Unfortunately, when you ultimately sell your units you “recapture” many of these offsets and pay Ordinary Income tax on this, now phantom, income. This is in addition to any capital gains tax.
Knowing a couple of IRS people allowed me to have a conversation with a K-1 IRS auditor. She said that many investors do get caught with negative basis. She did try to explain it to me, but I didn't know nearly enough to keep up. I do remember her saying things about "recapture" but exactly what I can't recall. Something that especially stands out in memory is that she regularly comes up against accountants who lose their arguments because the K-1 rules are quite complex. My takeway from the whole conversation was that I would sell all my regular-account MLPs and just stick with holding them in IRAs.