Yes, publicly traded partnerships are taxed as corporations unless they meet a specific exception. Internal Revenue Code Section 7704 treats partnerships whose interests trade on an established securities market or readily trade on a secondary market as corporations for federal tax purposes. Congress enacted this rule in 1987 to prevent businesses from avoiding corporate-level taxation while accessing public capital markets.
The Omnibus Budget Reconciliation Act of 1987 created Section 7704 because lawmakers worried about the “disincorporation of America.” Between 1981 and 1987, hundreds of businesses reorganized from corporations into publicly traded partnerships to eliminate one layer of taxation. This shift threatened to erode the corporate tax base by billions of dollars annually, prompting Congress to close what many viewed as a loophole that gave publicly traded partnerships an unfair advantage over traditional corporations.
Approximately 45 publicly traded partnerships exist today, down from their peak in the early 2010s when the sector represented over $270 billion in market capitalization. Most of these entities operate in the energy infrastructure sector, where they transport, store, and process natural gas, crude oil, and related products through vast pipeline networks spanning the United States.
What You Will Learn:
📊 How the 90 percent qualifying income test determines whether your publicly traded partnership pays corporate tax or maintains pass-through treatment
⚖️ The exact consequences of failing the qualifying income test, including double taxation at both corporate and individual levels that can slash your after-tax returns
💰 Which specific types of income count as qualifying income under Section 7704(d), from interest and dividends to natural resource operations
🚨 The common mistakes investors make with publicly traded partnerships that trigger unexpected tax bills, multistate filing requirements, and IRS penalties
🎯 Real-world examples from major master limited partnerships like Enterprise Products Partners and Energy Transfer that illustrate how these rules work in practice
Understanding the General Rule: PTPs as Corporations
Section 7704(a) establishes the baseline rule that publicly traded partnerships must be treated as corporations for federal income tax purposes. A publicly traded partnership exists when partnership interests are either traded on an established securities market such as the New York Stock Exchange or readily tradable on a secondary market. This definition captures not just partnerships listed on major exchanges but also those whose units trade through alternative trading systems or private marketplaces that provide similar liquidity to public exchanges.
The classification as a corporation triggers immediate and significant tax consequences. Partnerships taxed as corporations must file Form 1120 (U.S. Corporation Income Tax Return) instead of Form 1065 (U.S. Return of Partnership Income). The entity pays federal income tax at the corporate rate of 21 percent on its taxable income before any distributions reach investors.
This creates the dreaded double taxation scenario. The partnership pays tax at the entity level on its profits. When the partnership then distributes those after-tax profits to unit holders, those distributions are treated as taxable dividends to the recipients rather than as tax-advantaged partnership distributions or return of capital.
For an investor in the 37 percent individual tax bracket receiving qualified dividends taxed at 20 percent, the combined effective tax rate approaches 37 percent when you account for both layers of taxation. The corporation pays 21 percent tax, leaving 79 cents of each dollar. When that 79 cents is distributed as a dividend and taxed at 20 percent, the investor receives approximately 63 cents after all taxes, resulting in a combined tax burden of 37 percent.
The Critical Exception: The 90 Percent Qualifying Income Test
Congress recognized that certain types of income do not warrant the harsh corporate taxation treatment. Section 7704(c) provides a crucial exception that allows publicly traded partnerships to maintain their pass-through tax status if they meet a specific income threshold. The partnership must derive at least 90 percent of its gross income from qualifying sources for each taxable year.
The 90 percent qualifying income requirement applies on an annual basis. A partnership that meets the test in Year 1 but fails in Year 2 loses its pass-through status starting in Year 2. Conversely, a partnership formed as a corporation can elect partnership status beginning in any year it first satisfies the 90 percent test.
Partnership managers must carefully monitor their income mix throughout each tax year. Many partnerships that flirt with the 90 percent threshold implement strict policies prohibiting activities that generate non-qualifying income. Others establish separate corporate subsidiaries to hold assets or conduct operations that produce non-qualifying income, effectively filtering that income out of the partnership’s gross income calculation.
The calculation focuses on gross income, not net income. A partnership cannot offset non-qualifying gross income with deductions, losses, or expenses to meet the 90 percent threshold. If a partnership has $100 million in qualifying gross income and $11 million in non-qualifying gross income, it fails the test even though the non-qualifying income might produce a net loss after associated expenses.
What Counts as Qualifying Income Under Section 7704(d)
Section 7704(d)(1) provides an exhaustive list of income types that qualify for the exception. Understanding these categories is essential because even minor amounts of the wrong type of income can push a partnership over the 10 percent non-qualifying threshold.
Passive Investment Income forms the first category of qualifying income. This includes interest income (except interest derived from conducting a financial or insurance business), dividends, real property rents that would qualify under Section 856(d), and gains from the sale or disposition of real property. Congress included these items because partners could earn this type of income by investing directly in the underlying assets, making partnership-level taxation unnecessary.
Natural Resources Income represents the largest and most important category for most publicly traded partnerships. Section 7704(d)(1)(E) specifies that qualifying income includes income and gains from exploration, development, mining, production, processing, refining, transportation, or marketing of any mineral or natural resource. This broad category encompasses activities related to oil, natural gas, coal, minerals, fertilizer, geothermal energy, timber, and industrial source carbon dioxide.
The mineral or natural resource must be a product with respect to which a depletion deduction is allowable under Section 611. This requirement excludes products of farming, ranching, fishing, and power generated from hydroelectric, nuclear, solar, and wind sources. A partnership that generates electricity from solar panels, for example, would produce non-qualifying income even though renewable energy seems similar to traditional energy sources.
Real Estate Investment Trust (REIT) and Regulated Investment Company (RIC) Qualifying Income also qualifies under Section 7704(d)(4). Any income that would constitute qualifying income under Sections 851(b)(2)(A) or 856(c)(2) can help a publicly traded partnership meet its 90 percent threshold. This provision creates symmetry between different types of publicly traded entities and acknowledges that certain passive income streams do not justify corporate-level taxation.
Capital Gains from Qualifying Assets round out the qualifying income categories. Gains from the sale or disposition of capital assets (or property described in Section 1231(b)) held for the production of any type of qualifying income listed above count as qualifying income themselves. A partnership that sells a pipeline used to transport natural gas realizes qualifying income from the sale even though the gain is not ongoing operational income.
The Three Most Common PTP Scenarios
Understanding how the qualifying income test works in practice requires examining real-world scenarios. The following three situations represent the most frequent fact patterns involving publicly traded partnerships and their tax treatment.
Scenario 1: Traditional Energy Infrastructure MLP
| Partnership Structure | Tax Treatment |
|---|---|
| Partnership operates 5,000 miles of natural gas pipelines charging transportation fees | 95% of gross income from pipeline transportation fees qualifies under Section 7704(d)(1)(E) |
| Partnership earns interest on $50 million in cash reserves | 4% of gross income from interest qualifies under Section 7704(d)(1)(A) |
| Partnership provides pipeline construction services to third parties for fixed fees | 1% of gross income from construction services does NOT qualify |
| Total qualifying income: 99% | Partnership maintains pass-through status and files Form 1065 |
Consider Enterprise Products Partners, one of the largest publicly traded partnerships with a market capitalization exceeding $63 billion. The partnership operates an extensive network of pipelines, processing plants, and storage facilities for natural gas, natural gas liquids, crude oil, refined products, and petrochemicals. Substantially all of Enterprise’s income derives from fee-based contracts to transport and process hydrocarbons, with minimal exposure to commodity price fluctuations.
Enterprise carefully structures its operations to ensure qualifying income consistently exceeds 99 percent of gross income. The partnership charges fees for moving molecules through its infrastructure, processing raw natural gas into valuable liquid products, and storing hydrocarbons at strategically located facilities. Each of these activities generates qualifying income under Section 7704(d)(1)(E) as transportation, processing, or marketing of natural resources.
The partnership earns modest amounts of interest income on its cash balances and working capital, which also qualifies under Section 7704(d)(1)(A). Enterprise avoids activities that would generate non-qualifying income, such as retail sales to end consumers, manufacturing of products not derived from natural resources, or providing services unrelated to its core midstream operations. This disciplined approach to income composition allows Enterprise to maintain partnership tax treatment while accessing public capital markets for growth capital.
Scenario 2: Asset Management PTP Conversion
| Partnership Activity | Tax Consequence |
|---|---|
| Partnership earns management fees from advising investment funds (active business income) | Management fee income does NOT qualify under Section 7704(d) |
| Partnership receives performance-based incentive allocations from fund profits | Incentive allocation income does NOT qualify |
| Partnership holds investments in portfolio companies generating dividends | Dividend income qualifies under Section 7704(d)(1)(B) |
| Total qualifying income: 15% | Partnership FAILS 90% test and is taxed as corporation |
Several asset management firms organized as publicly traded partnerships in the 2000s, including prominent names in private equity and hedge fund management. These partnerships traded on the New York Stock Exchange, providing liquidity to their founders and early investors while raising additional capital for expansion. The partnerships earned revenue primarily from management fees (typically 1.5 to 2 percent of assets under management) and performance fees (typically 20 percent of profits above a hurdle rate).
Asset management income constitutes active business income from providing services rather than passive investment income or natural resources income. The management fees represent compensation for analyzing investments, making allocation decisions, monitoring portfolio companies, and providing strategic guidance. Performance fees represent a share of profits earned through active trading or operational improvements at portfolio companies. Neither type of income fits within any category of qualifying income under Section 7704(d).
Many of these partnerships also held investments in portfolio companies that paid dividends or made distributions. Those dividend payments constitute qualifying income under Section 7704(d)(1)(B). However, the management and performance fees typically dwarfed the investment income, causing total qualifying income to fall well below the 90 percent threshold.
These partnerships faced a choice: convert to corporate tax status and pay entity-level taxes, or de-list from public exchanges to regain partnership classification by eliminating the publicly traded element. Several chose to convert to corporations, triggering immediate tax consequences for their unit holders as discussed in the Mistakes to Avoid section below.
Scenario 3: Mixed Income Partnership Near the Threshold
| Income Source | Percentage of Gross Income |
|---|---|
| Natural gas transportation and storage fees | 82% (qualifying) |
| Interest income from cash and short-term investments | 6% (qualifying) |
| Equipment rental income (not real property) | 5% (non-qualifying) |
| Consulting fees for pipeline design services | 4% (non-qualifying) |
| Foreign exchange gains from currency hedging | 3% (non-qualifying) |
| Total qualifying income: 88% | FAILS 90% test by 2 percentage points |
This scenario illustrates how seemingly minor income streams can cause a partnership to fail the qualifying income test. The partnership’s core business generates substantial qualifying income from natural gas operations. However, the partnership also engages in ancillary activities that produce small amounts of non-qualifying income.
Equipment rental income represents compensation for providing tangible personal property (compressors, valves, meters) to customers. Unless the equipment qualifies as real property, rental income does not meet the real property rents requirement of Section 7704(d)(1)(C). Consulting fees for engineering and design services constitute ordinary business income from providing professional services, which does not fit any qualifying category.
Foreign exchange gains present a particularly tricky issue. Many partnerships with international operations or dollar-denominated contracts hedge their currency exposure using forward contracts or currency swaps. Gains and losses from these hedges generally do not qualify under Section 7704(d) because they represent trading gains rather than income from minerals, natural resources, or passive investments. Even though the hedges may be commercially necessary to manage risk, the IRS views the resulting income as non-qualifying.
In this scenario, the partnership falls 2 percentage points short of the 90 percent threshold. The partnership must take immediate action to regain compliance. Options include discontinuing the non-qualifying activities, restructuring those activities into a separate corporate subsidiary, or accepting corporate tax status for all future years until it can restructure its income streams.
Real-World Examples: Leading Master Limited Partnerships
Examining actual publicly traded partnerships that successfully maintain pass-through status provides concrete illustrations of how sophisticated entities manage their qualifying income requirements.
Energy Transfer operates one of the largest diversified midstream energy companies in North America. The master limited partnership owns and operates approximately 140,000 miles of pipeline systems transporting natural gas, crude oil, natural gas liquids, and refined products across 44 states. Energy Transfer serves major producing regions including the Permian Basin, Eagle Ford Shale, Barnett Shale, and Bakken Shale.
The partnership generates substantially all its revenue from fee-based contracts with customers who pay to move products through Energy Transfer’s infrastructure. These transportation fees constitute qualifying income under Section 7704(d)(1)(E) as income from the transportation of minerals and natural resources. Energy Transfer also earns fees from storage services, treating and processing natural gas, and operating import/export terminals for liquified natural gas.
Energy Transfer has successfully maintained its partnership tax status since inception by meticulously managing its qualifying income percentage. The partnership distributes approximately 7.4 percent of its market value annually to unit holders in the form of quarterly cash distributions. Because Energy Transfer does not pay entity-level federal income tax, more cash flows through to investors compared to a similarly profitable corporation that must pay the 21 percent corporate tax before distributing remaining cash as dividends.
Enterprise Products Partners stands as the largest publicly traded partnership by market capitalization at approximately $63 billion as of early 2026. The partnership provides midstream energy services to producers and consumers of natural gas, natural gas liquids, crude oil, refined products, and petrochemicals. Enterprise’s integrated network includes more than 50,000 miles of pipelines, 260 million barrels of storage capacity, 14 natural gas processing plants, and 22 NGL and propylene fractionators.
Enterprise maintains one of the most consistent qualifying income profiles in the sector, typically reporting 99 to 100 percent qualifying income. The partnership focuses exclusively on midstream infrastructure assets that generate fee-based income from long-term contracts. Enterprise avoids upstream production activities (which involve commodity price risk) and downstream retail or manufacturing activities (which may generate non-qualifying income).
Unit holders in Enterprise receive distributions yielding approximately 6.5 to 7 percent annually. The partnership has increased its distribution for 25 consecutive years, demonstrating the stable cash flows that infrastructure-focused master limited partnerships can generate. Enterprise’s consistent performance and reliable distributions illustrate why many investors accept the tax complexity of publicly traded partnerships in exchange for high current income and tax-deferred cash flows.
ONEOK provides another example of a successful publicly traded partnership structure. ONEOK operates in the natural gas and natural gas liquids segments, gathering, processing, storing, and transporting natural gas and natural gas liquids. The partnership serves the Williston, Permian, and Mid-Continent basins with gathering systems, processing plants, fractionation facilities, and pipeline networks.
These three partnerships collectively represent over $175 billion in market capitalization and distribute more than $10 billion annually to their unit holders. Their success in maintaining partnership tax status while operating massive publicly traded enterprises demonstrates that the Section 7704 framework works as Congress intended: passive investment income and infrastructure-based natural resources income can avoid corporate taxation, while active businesses that would normally incorporate remain subject to entity-level tax.
Breaking Down the Tax Treatment: How PTPs Actually Work
Understanding publicly traded partnerships requires examining how these entities function for both the partnership itself and for individual investors who own units.
At the Partnership Level, the entity files Form 1065 (U.S. Return of Partnership Income) if it meets the 90 percent qualifying income test. This information return reports the partnership’s income, gains, losses, deductions, and credits but calculates no tax liability. The partnership allocates each item among all unit holders based on their ownership percentages and issues Schedule K-1 forms to each partner detailing their share of every income and deduction item.
A publicly traded partnership meeting the qualifying income exception operates under all the normal partnership tax rules. The partnership maintains capital accounts for each partner tracking their economic interest in the entity. The partnership allocates income and loss to partners based on the partnership agreement, which typically follows a waterfall structure where certain partners (often the general partner) receive increasing percentages as distributions rise.
Partnership liabilities increase each partner’s outside basis in their partnership interest, allowing partners to deduct losses even when they have not invested additional cash. For publicly traded partnerships organized as limited partnerships, only recourse liabilities for which limited partners are personally liable increase those partners’ basis. Most publicly traded partnerships have minimal recourse debt attributable to limited partners, limiting their ability to deduct losses in excess of their invested capital and retained earnings.
At the Investor Level, unit holders report their share of the partnership’s tax items on their individual tax returns. This creates significantly more complexity than owning stock in a corporation. Stock ownership requires reporting only dividends received (on Form 1099-DIV) and capital gains or losses when shares are sold. Partnership ownership requires reporting potentially dozens of different income, deduction, and credit items on various forms and schedules of the individual return.
A typical Schedule K-1 from a publicly traded partnership may include ordinary business income, interest income, dividend income, capital gains, Section 1231 gains, Section 199A information for the qualified business income deduction, passive income or loss, self-employment income, tax credits, foreign tax credits, and state tax information. Each item flows to a different line on different tax forms or schedules when preparing the investor’s return.
Cash Distributions from publicly traded partnerships typically exceed taxable income allocated to partners. This occurs because partnerships can deduct depreciation and amortization on their assets, reducing taxable income without reducing cash flow. A partnership might generate $100 million in operating cash flow but report only $40 million in taxable income after $60 million in depreciation deductions.
This structure benefits partners in the short term because they receive cash exceeding the income they must report on their tax returns. The excess distribution reduces the partner’s outside basis in their partnership interest. Partners essentially receive a tax-free return of their investment. However, this creates future tax consequences because the reduced basis produces larger capital gains when the units are eventually sold.
Imagine you purchase 1,000 units in a publicly traded partnership for $30 per unit, investing $30,000. In Year 1, the partnership distributes $3 per unit ($3,000 total) but allocates only $1 per unit in taxable income ($1,000 total). You report and pay tax on $1,000 of income but receive $3,000 in cash. The $2,000 excess reduces your basis from $30,000 to $28,000. When you later sell your units for $35 per unit ($35,000 total), your gain is $7,000 ($35,000 sale price minus $28,000 adjusted basis) rather than $5,000 (sale price minus original $30,000 cost). The distributions were not truly tax-free—you merely deferred tax until the sale.
The Passive Activity Loss Rules add another layer of complexity for publicly traded partnerships. Section 469 limits the ability of investors to deduct losses from passive activities against other income such as wages or portfolio income. Most investors in publicly traded partnerships do not materially participate in the partnership’s business and therefore hold passive interests subject to the passive loss limitations.
Critically, Section 469(k) requires that each publicly traded partnership be treated separately for passive loss purposes. An investor cannot offset losses from one publicly traded partnership against income from a different publicly traded partnership. Losses from PTP A can only offset income from PTP A, not income from PTP B or income from non-PTP passive activities or non-passive income.
Passive losses that cannot be currently deducted because of this limitation carry forward indefinitely. The suspended losses can be used in a future year when the same publicly traded partnership generates passive income, or when the investor completely disposes of their entire interest in the partnership in a fully taxable transaction. Upon complete disposition, any remaining suspended passive losses become fully deductible against all types of income without limitation.
Why Congress Created Section 7704: Historical Context
The publicly traded partnership provisions of current law emerged from concerns about tax base erosion in the mid-1980s. Understanding this history illuminates why the rules take their current form and why the qualifying income exception exists.
The Tax Reform Act of 1986 represented the most comprehensive revision of the federal income tax system since World War II. Congress lowered individual tax rates dramatically, dropping the top rate from 50 percent to 28 percent while broadening the tax base by eliminating many deductions and preferences. To maintain revenue neutrality, the legislation repealed the General Utilities doctrine, which had allowed corporations to distribute appreciated property to shareholders without recognizing corporate-level gain.
The 1986 Act also lowered the top individual tax rate below the corporate tax rate for the first time in decades. Individuals faced a maximum 28 percent rate while corporations paid 34 percent on income over specified thresholds. This rate differential created a strong incentive to organize businesses as pass-through entities rather than C corporations, since pass-through income would be taxed only once at the lower individual rate rather than facing double taxation at the higher corporate rate followed by individual-level tax on dividends.
Master Limited Partnerships proliferated rapidly after 1986. The first MLP organized in 1981 when Apache Petroleum Company restructured to provide liquidity to its owners while maintaining partnership taxation. By 1987, dozens of businesses ranging from oil and gas producers to restaurant chains to real estate ventures had reorganized as publicly traded partnerships or announced plans to do so.
The trend alarmed policymakers who worried about “disincorporation of America” and the potential loss of billions in corporate tax revenue. If every business could access public capital markets while avoiding corporate taxation by organizing as a publicly traded partnership, the corporate tax base would erode dramatically. Congress viewed this as unfair tax competition that distorted business decisions and created inefficiencies in the capital markets.
The House Ways and Means Committee stated in its report on the 1987 legislation that “favoring one type of business investment over another creates new economic inefficiencies of the type that the 1986 Act was designed to reduce.” The Committee emphasized that businesses should make organizational and operational decisions based on commercial considerations rather than tax considerations.
Section 7704 emerged as the solution. Enacted as part of the Omnibus Budget Reconciliation Act of 1987, the provision generally treats publicly traded partnerships as corporations while creating a narrow exception for partnerships deriving passive investment income or income from natural resources infrastructure. Congress reasoned that passive income and natural resources infrastructure income did not raise the same policy concerns as active operating businesses.
For passive investment income, partners could earn the same income by investing directly in the underlying assets without interposing a partnership. Taxing the partnership as a corporation would merely add an unnecessary layer of tax without serving any policy goal. For natural resources income, Congress recognized that oil and gas pipelines, processing plants, and storage facilities had historically been developed in partnership form and that these infrastructure assets generated stable, predictable cash flows more similar to passive investments than active operating businesses.
The Grandfather Provision provided a transition period for existing publicly traded partnerships. Partnerships publicly traded before December 31, 1987 could continue to be taxed as partnerships without meeting the 90 percent qualifying income test until January 1, 1998 (later extended to 2005 for some partnerships). Alternatively, these grandfathered partnerships could elect to continue partnership treatment indefinitely by paying a 3.5 percent excise tax on their gross income from the active conduct of trades or businesses.
Few partnerships took advantage of the excise tax election because the 3.5 percent excise tax eroded much of the benefit of avoiding the 35 percent corporate tax. Most grandfathered partnerships either restructured their operations to meet the qualifying income test, converted to corporate tax status, or de-listed from public exchanges to eliminate their publicly traded status.
Mistakes to Avoid: Common PTP Investor Errors
Investors in publicly traded partnerships frequently make mistakes that result in underpaid taxes, IRS penalties, or loss of valuable tax benefits. Understanding these pitfalls helps you avoid costly errors.
Failing to Track Basis Adjustments represents the most common and expensive mistake. Your basis in publicly traded partnership units changes every year based on your share of income, loss, and distributions. The Schedule K-1 shows your allocable share of income (which increases basis) and loss (which decreases basis). Cash distributions also reduce basis dollar-for-dollar.
Many investors rely on their broker’s cost basis records when selling units. Brokers typically track only the purchase price and do not have access to the annual Schedule K-1 information needed to properly adjust basis. An investor who relies on the broker’s records will overstate their capital gain and overpay taxes when they sell their units.
Consider an investor who purchases 500 units for $25 per unit ($12,500 cost basis). Over five years, the partnership allocates $5,000 of income (increasing basis to $17,500) and distributes $8,000 in cash (decreasing basis to $9,500). When the investor sells all units for $30 per unit ($15,000), the actual gain is $5,500 ($15,000 minus $9,500 adjusted basis). However, if the investor uses the broker’s records showing the original $12,500 cost, they will report only $2,500 of gain, understating their income by $3,000 and risking an IRS examination and accuracy penalties.
Ignoring State Filing Requirements creates another widespread problem. When you own units in a publicly traded partnership, you have an ownership interest in a business operating in multiple states. Most publicly traded partnerships operate in 10 to 40 states through their pipeline systems, processing plants, storage facilities, and other infrastructure assets. The partnership allocates your share of income to each state based on where the partnership’s operations and property are located.
Many states require nonresident partners to file state income tax returns and pay tax on their share of income sourced to that state. Even if your allocable share of income from a particular state is small, the state may impose minimum filing requirements, penalties for late filing, and interest on unpaid taxes. Some investors face filing requirements in 20 or more states from a single publicly traded partnership investment.
The cost and complexity of multistate filing can exceed the investment income from smaller positions. Professional tax preparation fees rise dramatically when multiple state returns must be prepared. Some states offer composite return programs where the partnership pays tax on behalf of all nonresident partners, eliminating the need for individual returns, but not all partnerships participate in these programs and not all states offer them.
Missing Section 751 Ordinary Income on Sale creates unexpected tax liability. When you sell units in a publicly traded partnership, you must report not just capital gain but also ordinary income attributable to certain assets the partnership owns. Section 751 requires that gain attributable to the partnership’s unrealized receivables and substantially appreciated inventory be characterized as ordinary income rather than capital gain.
For publicly traded partnerships, the “hot assets” subject to Section 751 typically include the partnership’s inventory of oil, natural gas, or other commodities; unrecovered depreciation and amortization in partnership assets; and any accounts receivable. The Schedule K-1 package you receive when selling units includes detailed information about your Section 751 ordinary income.
This ordinary income must be reported on Form 4797 (Sales of Business Property) rather than Schedule D (Capital Gains and Losses). The ordinary income is taxed at your regular tax rates (up to 37 percent) rather than preferential long-term capital gains rates (0, 15, or 20 percent). Taxpayers who miss the Section 751 component and report the entire gain as capital gain will underreport their tax liability.
Even more surprising, Section 751 can require you to report ordinary income when you have an overall capital loss on the sale. Imagine selling units for less than you paid, expecting to report a capital loss. The Section 751 calculation might show $5,000 of ordinary income from hot assets, which you must report on Form 4797, along with a $7,000 long-term capital loss on Schedule D. You recognize the $5,000 of ordinary income in full but can deduct only $3,000 of capital loss per year (the limit for offsetting ordinary income with capital losses), causing you to pay tax on a transaction that lost money overall.
Overlooking the Section 199A Deduction means leaving money on the table. Section 199A allows individual taxpayers to deduct up to 20 percent of qualified business income from partnerships, S corporations, and sole proprietorships. Publicly traded partnerships receive special treatment under Section 199A, with simpler rules than apply to other pass-through entities.
The Schedule K-1 from a publicly traded partnership shows your qualified publicly traded partnership income eligible for the 20 percent deduction on a separate line. This amount is your share of the partnership’s income from qualifying business activities, reduced by certain excluded items like portfolio interest and dividends. The 20 percent deduction applies without regard to the W-2 wage limitations and qualified property limitations that restrict the Section 199A deduction for income from non-publicly traded partnerships.
Many tax preparation software packages do not automatically calculate the Section 199A deduction for publicly traded partnership income unless you specifically enter the amount from the Schedule K-1 instructions. Failing to claim this deduction costs you 20 percent of eligible income. On $10,000 of qualifying income, the missed deduction results in approximately $740 to $1,480 in additional tax (depending on your marginal tax rate).
Holding PTPs in Retirement Accounts triggers unrelated business taxable income problems. Many investors assume that retirement accounts like IRAs never owe tax on their investments. While this is true for most investments, it does not apply to income from master limited partnerships and other publicly traded partnerships.
When a tax-exempt entity like an IRA owns units in a publicly traded partnership, the IRA must report its share of the partnership’s business income as unrelated business taxable income and pay tax on UBTI exceeding $1,000 per year. The IRA must file Form 990-T (Exempt Organization Business Income Tax Return) and pay the applicable tax from the IRA’s assets, reducing the account value.
Most publicly traded partnerships generate at least some UBTI each year. The UBTI typically includes all operating income from the partnership’s business activities minus related deductions. Holding publicly traded partnership units in an IRA eliminates the tax deferral benefit that makes IRAs attractive for most investments. The IRA may also face tax on unrelated debt-financed income if the partnership has borrowed money to acquire assets.
Do’s and Don’ts for PTP Investors
Successfully navigating publicly traded partnership investments requires following certain practices and avoiding specific pitfalls.
Do’s
Do maintain detailed basis tracking worksheets from the date you acquire units through the date you sell them. Create a spreadsheet with columns for the date, description (purchase, income allocation, distribution, or sale), amount, and adjusted basis. Update this worksheet every year when you receive your Schedule K-1, adding income to basis and subtracting losses and distributions from basis. Keep copies of all Schedule K-1 forms you receive permanently, as you may need information from years earlier when you eventually sell your units.
Do research multistate filing requirements before investing in publicly traded partnerships. Obtain the prior year’s Schedule K-1 package from the partnership or your financial advisor to review the state tax information section. Count how many states allocated income to unit holders and determine whether those states require nonresident returns. Calculate the total cost of preparing additional state returns and compare that ongoing cost to the expected income and return from the investment. If the tax compliance costs exceed the income, consider alternative investments.
Do consider composite return participation if the partnership offers this option. Many publicly traded partnerships sponsor composite returns in multiple states, filing a single partnership-level return and paying tax on behalf of all participating nonresident unit holders. While you must authorize the partnership to file composite returns on your behalf, doing so eliminates your obligation to file individual state returns in those jurisdictions. Review the partnership’s website or contact investor relations to understand which states have composite programs and how to elect participation.
Do plan for quarterly estimated tax payments because publicly traded partnerships do not withhold tax on allocated income. Unlike wages (with withholding) or even corporate dividends (with backup withholding when required), partnership income allocations arrive with no withholding. You remain responsible for paying estimated taxes quarterly to avoid underpayment penalties. Factor your expected partnership income into your quarterly estimated tax calculations and increase withholding from other income sources if you do not want to make quarterly payments.
Do keep schedule K-1 packages intact rather than separating the K-1 from the supporting schedules and instructions. The Schedule K-1 itself is only the first few pages of a much longer document. Most publicly traded partnerships provide 30 to 100 pages of additional schedules, explanations, and state tax information essential for properly reporting your share of partnership items. The supporting schedules include Section 751 information needed when you sell units, Section 199A details for claiming your qualified business income deduction, and state-by-state income allocations for state tax returns. File these complete packages in a dedicated folder or digital repository organized by partnership name and year.
Do diversify across multiple PTPs if you want exposure to the master limited partnership sector. Owning 5 to 10 different publicly traded partnerships provides diversification benefits and reduces your risk from any single partnership failing, cutting its distribution, or experiencing operational problems. The additional tax complexity from multiple K-1 forms is manageable using tax preparation software or a qualified tax professional experienced with partnerships.
Do notify your tax preparer early if you buy, sell, or hold publicly traded partnerships. Many tax preparers charge additional fees for preparing returns with Schedule K-1 forms because of the increased complexity and time required. Your preparer needs adequate time to process the K-1 information, research unfamiliar items, and prepare the necessary state returns. Schedule K-1 forms for publicly traded partnerships often arrive in mid-March (well after W-2s and 1099s), pushing preparation into the final weeks before the April deadline. Give your preparer a heads-up about your partnership holdings when you first engage them for the year.
Don’ts
Don’t assume broker cost basis records are correct when selling publicly traded partnership units. Your broker tracks your purchase price but cannot access the Schedule K-1 information needed to adjust basis for allocated income, losses, and distributions. Calculate your own adjusted basis using your historical K-1 records or hire a tax professional to reconstruct basis if you did not track it contemporaneously. Report the correct basis on your tax return even if it differs from the Form 1099-B you receive from your broker.
Don’t sell units in December if you want to avoid complexity and maximize your investment return. Publicly traded partnerships establish their record dates for distributions near the end of each calendar quarter (typically in late February, May, August, and November). If you sell units between the record date and the payment date, you receive the cash distribution but the buyer receives the income allocation on their Schedule K-1. This mismatch creates basis adjustments and reporting complexities. Selling in January through November (avoiding the weeks surrounding the fourth quarter record date in November) eliminates this issue.
Don’t hold PTPs in tax-deferred or tax-exempt accounts unless you accept that you may owe unrelated business taxable income taxes and compliance costs. IRAs, 401(k) plans, and other retirement accounts are designed for passive investments like stocks, bonds, and mutual funds that generate portfolio income exempt from UBTI rules. Publicly traded partnerships generate active business income that produces UBTI for tax-exempt holders. The tax and Form 990-T filing requirement eliminate the tax-deferral benefit of retirement accounts.
Don’t ignore state filing requirements even if your allocable share of income from a particular state seems immaterial. States impose penalties for failure to file required returns regardless of the amount of income involved. Some states automatically assess minimum penalties of $50 to $200 for late returns even when no tax is due. The cumulative cost of penalties from multiple states can exceed your total distribution from the partnership. File all required state returns on time or participate in composite return programs where available.
Don’t forget the Section 751 disclosure statement when you sell units. The IRS requires both the partnership and the selling partner to attach disclosure statements to their tax returns in the year of a sale involving Section 751 assets. Your required disclosure statement should read: “The taxpayer has reported ordinary income upon the disposition of units in [Partnership Name], LP, as provided by the Partnership. The amount was determined in accordance with Internal Revenue Code Section 751. Detailed information is available from the Partnership upon request.” Include this statement with your Form 1040 to comply with the disclosure requirement.
Pros and Cons of the PTP Tax Structure
The publicly traded partnership structure offers distinct advantages and disadvantages compared to traditional corporate investments.
Pros
Higher distributable cash flow results from avoiding entity-level taxation. A publicly traded partnership meeting the qualifying income exception does not pay federal income tax, allowing it to distribute substantially all its operating cash flow to unit holders. A comparable corporation must pay 21 percent corporate tax before distributing the remaining 79 percent as dividends. This advantage means publicly traded partnerships can distribute 20 to 30 percent more cash annually than otherwise identical corporations, producing yields typically ranging from 6 to 8 percent compared to 2 to 3 percent for the average S&P 500 stock.
Tax deferral through depreciation pass-through allows investors to receive cash distributions exceeding their taxable income. Partnerships deduct depreciation and amortization on their infrastructure assets, reducing taxable income without reducing cash flow. These tax benefits flow through to unit holders, who report income less than the cash they receive. The difference represents tax-free return of capital (though it reduces basis, creating larger gains upon eventual sale). This tax deferral improves after-tax returns by allowing you to invest the tax savings and earn returns on money you would have otherwise paid to the IRS.
The Section 199A deduction provides an additional 20 percent deduction for qualified publicly traded partnership income. Individual unit holders can deduct 20 percent of their qualified PTP income, effectively reducing their tax rate on that income by 20 percent. An investor in the 37 percent bracket paying 37 percent tax on $10,000 of PTP income would owe $3,700 in tax. With the Section 199A deduction reducing taxable income to $8,000, the tax drops to $2,960, an effective rate of 29.6 percent (20 percent lower than the nominal rate).
No self-employment tax applies to publicly traded partnership income for limited partners. Unlike income from non-publicly traded partnerships where general partners (and sometimes limited partners) must pay self-employment tax on their distributive share, publicly traded partnership income is not subject to the 15.3 percent self-employment tax. This saves approximately $1,530 in tax on $10,000 of income compared to self-employment income.
Access to infrastructure assets provides diversification benefits. Most publicly traded partnerships own and operate energy infrastructure assets including pipelines, storage facilities, processing plants, and terminals. These assets generate relatively stable, predictable cash flows from long-term contracts with investment-grade customers. Individual investors cannot easily access these infrastructure investments except through publicly traded partnerships or infrastructure-focused funds. The income provides diversification away from traditional stocks and bonds with different return drivers.
Cons
Significant tax complexity increases compliance costs and error risk. Preparing a tax return with one or more Schedule K-1 forms from publicly traded partnerships requires substantially more time, expertise, and cost than a return with only W-2s and 1099s. Professional tax preparation fees typically increase by $250 to $500 per Schedule K-1, and more if state returns are required. The complexity creates opportunities for errors that can trigger IRS examinations, penalties, and interest.
Multistate filing requirements multiply compliance burden. A single publicly traded partnership investment can require filing income tax returns in 15 to 30 states, each with different forms, rules, payment procedures, and deadlines. The cost of preparing these state returns can approach or exceed the investment income from smaller positions. Some states require minimum tax payments, estimated tax installments, or impose filing fees that apply regardless of income level.
Delayed K-1 forms arrive weeks or months after W-2s and 1099s. Most publicly traded partnerships mail Schedule K-1 forms in mid-March, about two months after W-2s and 1099s arrive in January. This delay pushes tax return preparation into March and early April, leaving little time to prepare returns, discover issues, and file by the April deadline. Investors often must file extensions if they have publicly traded partnerships, delaying refunds and increasing compliance costs.
Basis tracking requirements create ongoing administrative burden. Unit holders must maintain detailed basis records throughout their ownership, updating basis annually for income, loss, and distributions. Failure to track basis accurately results in incorrect gain or loss calculations when units are eventually sold. Reconstructing basis years after the fact is difficult, time-consuming, and may be impossible if you do not have complete historical records.
Forced sales trigger unexpected taxes when publicly traded partnerships convert to corporate tax status or are acquired by corporations. Unit holders have no control over these corporate actions but face immediate tax consequences from transactions they did not initiate. The forced recognition of all deferred income (from prior tax-advantaged distributions that reduced basis) can create surprisingly large tax bills. Investors who planned to hold their units indefinitely, deferring taxes until retirement when they would be in lower tax brackets, lose this planning opportunity when conversions occur.
UBTI issues make publicly traded partnerships unsuitable for retirement accounts. Tax-exempt investors including IRAs, charitable organizations, and pension plans face unrelated business taxable income taxes on their share of partnership operating income. This tax obligation eliminates the primary advantage of tax-deferred and tax-exempt accounts. The Form 990-T filing requirement adds complexity and cost for investors who expected their retirement accounts to require no tax filings or payments during the accumulation phase.
Limited downside protection during industry downturns affects distribution sustainability. While publicly traded partnerships typically maintain distributions better than corporations maintain dividends during recessions, severe industry downturns can force distribution cuts. Many partnerships reduced distributions during the 2014-2016 oil price collapse when crude oil fell from over $100 per barrel to below $30 per barrel. Unit holders who relied on distribution income for living expenses faced unexpected income reductions with little warning.
State-Level Tax Treatment
While federal tax treatment follows the Section 7704 framework discussed above, state taxation of publicly traded partnerships varies significantly across jurisdictions.
Most states follow federal partnership classification for publicly traded partnerships that meet the 90 percent qualifying income test. If the entity is a partnership for federal purposes, these states treat it as a partnership for state income tax purposes and require the partnership to allocate income to unit holders based on each state’s sourcing rules. States that conform to federal tax law generally apply Section 7704 automatically, treating publicly traded partnerships failing the qualifying income test as corporations subject to state corporate income taxes.
California imposes unique rules and fees on partnerships doing business in the state. Limited partnerships and limited liability companies pay an annual $800 minimum tax to the California Franchise Tax Board regardless of income. Entities with California-source gross receipts exceeding $250,000 pay an additional fee ranging from $900 (for gross receipts of $250,000 to $499,999) to $11,790 (for gross receipts of $5 million or more). These fees apply to the partnership entity and are separate from the income tax liabilities of individual unit holders.
California also requires partnerships to withhold 7 percent of distributions to nonresident unit holders and remit the withholding to the Franchise Tax Board. This withholding provides California with current payment of tax on nonresidents’ California-source income. Nonresident unit holders claim the withholding as a credit on their California nonresident income tax returns, effectively making it a prepayment of their California tax liability.
Texas does not impose an individual income tax but does impose a franchise tax on partnerships with revenues exceeding $1.23 million. The franchise tax applies at a rate of 0.375 percent to 0.75 percent of the partnership’s Texas gross receipts (with certain deductions). Partnerships can qualify as passive entities exempt from franchise tax if at least 90 percent of their gross income consists of specified passive income types. The qualifying income categories for Texas franchise tax purposes mirror but are not identical to the Section 7704(d) federal qualifying income categories.
New York requires partnerships to file Form IT-204 (Partnership Return) and charges a filing fee based on the number of partners. New York also imposes the Unincorporated Business Tax at a rate of 4 percent on income allocated to New York City from unincorporated businesses including partnerships. This tax applies at the entity level but is calculated based on the share of income allocated to partners who are subject to the tax. Unit holders in publicly traded partnerships with operations in New York City may owe both individual income tax and their share of the Unincorporated Business Tax.
State composite returns offer an alternative to individual state filings for nonresident partners. Many states permit or require partnerships to file composite returns reporting and paying tax on behalf of all consenting nonresident partners. The partnership files a single return, reports the aggregate income allocated to participating nonresidents, and pays tax at a specified rate (often the highest marginal rate). Nonresidents who participate in the composite return do not file individual state returns for income from that partnership.
Publicly traded partnerships frequently sponsor composite return programs in the states where they operate. Check the investor relations section of the partnership’s website or the state tax information section of your Schedule K-1 package for details about composite return availability and election procedures. Participating in composite returns dramatically simplifies state tax compliance at the cost of potentially paying slightly higher state taxes than you would owe on an individual return (since the composite return typically applies the highest state tax rate to all income).
How to Determine if a Partnership Meets the 90 Percent Test
Partnership managers must calculate their qualifying income percentage at least annually, and sophisticated partnerships monitor the percentage quarterly or even monthly to avoid inadvertent failures.
The calculation divides qualifying gross income by total gross income for the taxable year. Gross income includes all revenue and gains recognized by the partnership without reduction for cost of goods sold, operating expenses, interest expense, depreciation, or other deductions. The test focuses on the composition of gross income, not net income or taxable income.
Start by identifying every source of gross income the partnership recognized during the year. Common sources include fees for transportation services, fees for processing or treating products, storage fees, product sales, interest income, dividend income, rental income, and gains from property sales. List each income source separately with the dollar amount of gross income from that source.
Next, classify each income source as qualifying or non-qualifying under Section 7704(d). Use the categories discussed earlier: interest, dividends, real property rents, real property gains, natural resources income, REIT/RIC income, and capital gains from assets held to produce qualifying income. Income that does not fit one of these categories is non-qualifying.
Calculate the percentage by dividing total qualifying gross income by total gross income and multiplying by 100. A partnership with $450 million in qualifying gross income and $50 million in non-qualifying gross income has total gross income of $500 million and a qualifying income percentage of 90 percent ($450 million ÷ $500 million × 100 = 90.0%). This partnership exactly meets the threshold and maintains partnership tax status.
Revenue recognition timing affects the qualifying income calculation. The partnership must apply consistent revenue recognition methods across all income sources. Most partnerships use accrual method accounting, recognizing income when earned regardless of when cash is received. The qualifying income test applies to income recognized during the year under the partnership’s method of accounting, not to cash received.
Hedging income presents particular complexity. Many publicly traded partnerships hedge their commodity price exposure, interest rate risk, or foreign currency risk. The tax treatment of hedging gains and losses depends on whether the hedge qualifies as a hedging transaction under Section 1221(b)(2). Qualifying hedges generally produce ordinary income or loss that may be treated as qualifying income if the hedged item produces qualifying income. Non-qualifying hedges produce capital gain or loss that may or may not constitute qualifying income depending on the specific facts.
The IRS has issued numerous private letter rulings addressing whether specific income streams constitute qualifying income. These rulings provide guidance for similar situations but are binding only on the specific taxpayer that requested the ruling. However, the rulings collectively illustrate how the IRS applies the qualifying income definitions to novel fact patterns. Partnerships considering activities that may generate non-qualifying income should review relevant private letter rulings or request their own ruling for certainty.
FAQs
Can I hold PTP units in my IRA or 401(k) account?
Yes, but your retirement account may owe unrelated business taxable income tax if the PTP generates more than $1,000 in UBTI annually, which most do. The account must file Form 990-T and pay tax, eliminating tax deferral benefits.
Do PTPs pay dividends like corporations?
No. PTPs make quarterly cash distributions to unit holders, but these distributions are not dividends. Distributions generally exceed taxable income allocated to partners, with the excess reducing basis as tax-deferred return of capital.
What happens if a PTP fails the 90 percent test in one year?
The PTP is taxed as a corporation starting that year. It must file Form 1120, pay corporate income tax, and treat distributions as taxable dividends. The partnership can revert to pass-through status in any future year it again meets the test.
Are PTP distributions qualified dividends?
No. PTP distributions are not dividends at all and do not qualify for qualified dividend preferential tax rates. Unit holders report their share of partnership income items on their returns, which may include ordinary income, capital gains, and other categories.
How do I report PTP income on my tax return?
Use the Schedule K-1 (Form 1065) from the partnership to report your share of income, deductions, and credits on the appropriate lines of your Form 1040 and related schedules. Different items flow to different forms.
What is Section 751 ordinary income?
Section 751 requires gain from selling partnership interests to be partly ordinary income rather than capital gain for the portion attributable to the partnership’s unrealized receivables and substantially appreciated inventory, called “hot assets.”
Can PTP losses offset my salary or investment income?
No. PTP losses are passive losses subject to Section 469(k), which prohibits offsetting them against non-passive income or income from different PTPs. Losses suspend until you have income from the same PTP or dispose of your entire interest.
Do I need to file state tax returns if I own PTP units?
Yes, in most states where the PTP operates and allocates income to you. You may need to file 10 to 30 state returns annually unless you participate in composite return programs the PTP offers.
What is the Section 199A deduction for PTPs?
The Section 199A deduction allows you to deduct 20 percent of qualified PTP income on your individual return, effectively reducing your tax rate on that income. The deduction has simpler rules for PTPs than other pass-through entities.
Can a PTP invest in renewable energy projects?
Yes, but income from renewable energy often does not qualify under Section 7704(d)(1)(E). Solar, wind, and hydroelectric power generation do not involve minerals or natural resources as defined. PTPs in renewable energy typically use corporate subsidiaries for non-qualifying activities.
How is PTP basis calculated when units are inherited?
Heirs receive a step-up in basis to fair market value at the date of death under Section 1014, eliminating all built-in gain. However, heirs must consider income in respect of a decedent rules for certain partnership items.
What happens when a PTP converts to a corporation?
The conversion triggers a taxable event for unit holders, who recognize all deferred income from past distributions that reduced basis. Recaptured depreciation is taxed as ordinary income, potentially creating large unexpected tax bills for long-term unit holders.
Are foreign investors subject to withholding on PTP income?
Yes. PTPs must withhold tax under Section 1446(a) on effectively connected income distributed to foreign partners at rates of 37 percent for individuals and 21 percent for corporations, using Forms 1042 and 1042-S.
How long do I need to keep PTP records?
Keep all Schedule K-1 forms permanently. You need historical K-1s to calculate adjusted basis when you sell units, which may be years or decades after you received them. Also keep year-of-sale schedules for seven years.
What is an MLP vs. a PTP?
A Master Limited Partnership is a type of publicly traded partnership organized as a limited partnership with units traded on major exchanges. All MLPs are PTPs, but not all PTPs are MLPs. The terms are often used interchangeably.
Related reading
- Are Publicly Traded Partnerships Passive Income? (w/Examples) + FAQs
- Can a Partnership Be Publicly Traded? (w/Examples) + FAQs
- Do Publicly Traded Partnerships Qualify for QBI? (w/Examples) + FAQs
- How Are Publicly Traded Partnerships Taxed? (w/Examples) + FAQs
- Are General Partnerships Double-Taxed? (w/Examples) + FAQs
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- How to Structure a Limited Partnership (w/Examples) + FAQs