7 MLP Tax Mistakes That Trigger IRS Notices (And How to Avoid Them)

MLP taxation is fundamentally different from stock taxation. When you own shares of a normal corporation, your broker tracks everything — cost basis, dividends, splits. When you sell, the 1099-B is accurate and your tax software handles the rest. MLPs don't work this way. Partnerships are pass-through entities, which means the IRS holds you responsible for calculating your own basis, tracking your share of income and deductions, and reporting the correct numbers at sale.

Your broker can't help because they never receive K-1 data. Your tax software processes what you enter but can't validate it. And the IRS receives every K-1 issued to you — they know what the numbers should be, even if you don't. This combination creates a perfect storm for errors, and the seven mistakes below account for the vast majority of IRS notices, underpayments, and overpayments among MLP investors.

This is the single biggest and most expensive MLP tax mistake. When you sell MLP units, your broker reports cost basis on Form 1099-B — but that number is your original purchase price, never adjusted for years of K-1 activity. Distributions, income allocations, liability changes, and depreciation deductions all modify your real basis every year. Your broker never sees any of it.

After 5–10 years of holding, the gap between your broker's basis and your real K-1-adjusted basis can be thousands of dollars per lot. This isn't a gray area or an edge case — the IRS receives a copy of every K-1 issued to you and knows what your basis should be. Their Automated Underreporter (AUR) system flags the mismatch automatically.

Consequences: A CP2000 notice (proposed adjustment), additional tax on the unreported gain, interest calculated from the original due date, and a potential 20% accuracy-related penalty under IRC §6662 if the understatement exceeds the greater of $5,000 or 10% of the tax required to be shown on the return.

For the full explanation of why brokers get this wrong and how to fix it on Form 8949, see Why Your Broker's MLP Cost Basis Is Wrong.

When you sell MLP units, part of your gain is not capital gain at all. Under Section 751 of the Internal Revenue Code, a portion of your proceeds is reclassified as ordinary income — taxed at your marginal rate, up to 37%. This is not optional. It's not an edge case. It applies to virtually every MLP sale where the partnership has depreciable assets.

The §751 amount appears on your final-year K-1's Sales Schedule. It represents your share of the partnership's cumulative depreciation — income you effectively deferred through annual deductions that now must be "recaptured" as ordinary income at disposition.

Many investors report their entire MLP sale as capital gain on Schedule D. The IRS will reclassify the §751 portion, resulting in higher tax owed (ordinary rates vs. capital gains rates), plus interest from the original due date.

For a complete breakdown of how §751 recapture works and how to report it correctly, see Section 751 Depreciation Recapture Explained.

Energy Transfer (ET) is one of the most widely held MLPs — and one of the most commonly misreported. When you own ET units, you don't own one partnership. You own interests in three separate partnerships, each with its own EIN, its own K-1, and its own income allocations:

• Energy Transfer LP — the parent entity
• USA Compression Partners (USAC) — compression services subsidiary
• Sunoco LP (SUN) — fuel distribution subsidiary

If you only enter one K-1, you're underreporting income from two partnerships. The IRS receives all three K-1s and their automated system will flag the missing ones. This generates a CP2000 notice for each missing K-1 — potentially three separate correspondence cycles with the IRS.

For the full guide on handling all three ET entities, see Energy Transfer (ET) K-1 Guide.

MLPs operate in multiple states, and your K-1 shows income allocated to each state where the partnership conducts business. If your allocated income in a particular state exceeds that state's de minimis filing threshold, you owe a non-resident state tax return — even if you've never set foot in that state.

For midstream MLPs with pipeline networks spanning dozens of states, this can mean filing obligations in states you've never even thought about. Common states for midstream MLP investors include Louisiana, Pennsylvania, Ohio, Oklahoma, West Virginia, New Mexico, and Colorado. States with no income tax (Texas, Wyoming, Florida) don't require filing, but others do.

Consequences: State tax penalties, back taxes with interest, and in some cases, a state establishing nexus that affects your other income. States are increasingly sharing data and using K-1 information to identify non-filers.

For a state-by-state breakdown of thresholds and requirements, see MLP State Filing Requirements.

Publicly Traded Partnerships have special loss rules under IRC §469(k) that most investors don't know about. Unlike ordinary passive activity losses — which can offset income from other passive activities — PTP losses are quarantined. They can only offset income from the same PTP.

If your MLP shows a Box 1 loss in a given year, that loss is suspended. It carries forward indefinitely, but it can only be used in two ways: offset future income from that same PTP, or be released when you dispose of your entire interest in that PTP.

The mistake happens when investors — or their tax software — net PTP losses against rental income, other MLP income, or other passive income sources. This creates an incorrect return. Tax software must have the PTP checkbox properly flagged for each MLP to apply the §469(k) limitation correctly.

Many investors hold MLPs in IRAs thinking the tax-advantaged wrapper protects them from K-1 complexity. It doesn't. MLPs generate Unrelated Business Taxable Income (UBTI) that flows through to the IRA. If UBTI exceeds $1,000 in a tax year, the IRA itself must file Form 990-T and pay tax directly from IRA funds.

In most normal holding years, midstream MLPs generate modest or even negative UBTI (because depreciation deductions offset business income). The danger comes from exceptional events: asset sales by the partnership, mergers, restructurings, or selling your MLP units inside the IRA. A sale inside the IRA triggers §751 recapture as UBTI — potentially creating thousands of dollars of taxable income inside your supposedly tax-free account.

For the full guide on UBTI rules, Form 990-T filing, and strategies for managing MLPs in retirement accounts, see MLPs in Your IRA: UBTI Explained.

The ultimate MLP tax mistake is simply not tracking basis. Every year you hold MLP units, distributions reduce your basis and K-1 adjustments change it further. Without tracking, you have no idea what your real basis is — and neither does your broker, your tax software, or the IRS (though the IRS has the data to reconstruct it).

This mistake compounds in three ways:

• At sale: You can't report the correct basis on Form 8949. You're forced to either guess, use the broker's wrong number, or reconstruct years of K-1 data under time pressure during tax season.
• During holding: You can't detect when your basis hits zero. Once basis reaches zero, distributions become immediately taxable as capital gain under §731 — even without selling. If you don't know your basis is zero, you're not reporting this taxable event.
• At death or gift: When units pass to heirs (stepped-up basis) or are gifted (carryover basis), the correct basis at transfer is needed. Without records, heirs may use the broker's wrong number or have no basis documentation at all.

This is also the easiest mistake to fix. You can start tracking now, even retroactively. Historical K-1s are available from Tax Package Support for most MLPs, and each year's calculation builds sequentially from the prior year's ending basis. The sooner you start, the fewer years you need to reconstruct.

For a walkthrough of how distributions reduce your basis year by year, see How MLP Distributions Erode Your Basis.

Most of these mistakes are fixable. Amended returns (Form 1040-X) can correct the last three years. State returns can be filed late with minimal penalties in most cases. And basis tracking can be started retroactively at any time. The only mistake that gets worse by waiting is the last one — not tracking basis at all.