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Taxes and Your IRA

IRA Guide

Master Limited Partnerships (MLPs), Taxes & Your IRA

Aaron Levitt Jul 11, 2016


Since the Fed has kept interest rates low for so long, investors looking for income have moved into unchartered territory. A variety of new asset classes – like floating rate loans and real estate investment trusts (REITs) – have gotten the nod in portfolios. One of those new asset classes has been master limited partnerships (MLPs).


Prized for their “pass-through” nature and high distributions, plenty of investor money has flowed into MLPs. However, the problem is where this “money” is located.

With retirement accounts such as IRAs and rollovers conspiring for the vast bulk of investors’ savings, they could be doing themselves more harm than good by investing in MLPs in these accounts. Because of some interesting tax quirks, IRAs may not be the best place to hold them. Not that you can’t, but there are some things investors should be aware of.

Here’s Dividend.com’s guide to MLPs and IRAs.


“Pass-Through” Is the Key


Back in the 1980s – after a nasty oil bust and the oil embargo of the 1970s – Congress tweaked the tax code so that firms engaged in the “exploration & production, development, mining, refining, transportation or the marketing of any mineral or natural resource” could set up an MLP and pay no corporate tax on the assets in the vehicle. The pipelines (or what have you) would be able to “pass-through” their cash flows back to unit holders of the partnership tax free. That helps them to have yields in the 5-7% range.

When holding these vehicles in a taxable account as intended, that “pass-through” nature pushes the MLPs tax-related stuff back to investors. As partnerships, MLPs issue a special statement called a K-1 form around March. The K-1 is vastly different than a traditional 1099 form and spells out how much income, deductions and other tax-related nonsense is allocable to investors based on their interest in the partnership: you own this many units; therefore, this is how much XYZ you owe.

Most investors fear the dreaded K-1 statement as it adds complication come tax time. Given that – and the fact that most of our assets are in retirement/tax-sheltered accounts – many investors have begun placing MLPs inside IRAs and similar vehicles to avoid the K-1.


You’ll Still Get the K-1


While that may seem like a good idea at first, it may not be such a good idea after all. For starters, you’re still going to get that K-1 statement and you’re going to need to look at it perhaps even closer.

Another section of our massive tax code, I.R.C. §§511-514, creates a provision called unrelated business taxable income (UBTI). Here tax-exempt organizations and retirement accounts must pay tax on their share of UBTI. Basically, the income from a business that is not related to their exempt purpose.

In order to qualify for MLP status, 90% of their activity must come from qualifying sources – but not all of it does or has to. If a pipeline MLP decides to open up a pizza stand, the pizza assets would generate UBTI for the partnership.

The headache is that some MLPs do generate UBTI via ownership of crazy assets. The issue is that when you place a MLP inside an IRA, you don’t own the MLP. Your IRA is considered the owner. It’s the limited partner in that MLP and subject to all the goodies described on the K-1.

The IRS allows IRAs to have up to $1,000 worth of UBTI in them. More than that – and your IRA will owe the tax. The custodian of the account will file a special 990-T form and pay what is owed via assets from the savings vehicle. Typically, they’ll drain any cash holdings first, but if that isn’t sufficient, they will sell various stocks, mutual funds, ETFs and even the MLP itself in order to have the IRA pay the tax. Depending on how the custodian agreement is written, you may have little say on what they choose to sell.

Moreover, the tax rate here is currently at the highest rate of 39.6%


Losing the Tax Benefits


Another problem with MLPs in IRAs is that you lose on the best advantages of them: their tax deferrals. MLPs high distributions, for the most part, are considered “returns of capital.” As such, they reduce your cost basis in the MLP and aren’t taxed right away. When you sell the units, you would then pay the tax on the new cost basis. By placing them in a tax-deferred vehicle like IRA, you basically waste this fact. Most investors wouldn’t think about placing tax-free municipal bonds in an IRA. The same sort of concept applies to MLPs.


So Should You Place MLPs in IRAs?


Can you place MLPs inside your IRA? Technically, you can. There’s no IRS rule that says you can’t. And with the vast bulk of master limited partnerships, the amount of UBTI they generate is a big fat zero. Most stick to their mandates of owning pipelines, gathering systems and the like. Most investors’ UBTI won’t ever get close to that magical $1,000 number.

If you’re going own one or two bread-n-butter MLPs in an IRA, you’re probably going to be all right. The key would be position size and checking that K-1 statement to make sure that it’s not getting close to that $1,000 mark. If it is, then it’s time to sell.

The real question is whether or not you want to place them in an IRA. Given their already ingrained tax advantages, MLPs are best suited as taxable accounts.


The Bottom Line


Given their high distributions, MLPs have exploded in popularity. But a lot of investors may be doing themselves a disservice by placing them inside their IRAs or other retirement vehicles. There are some unique tax pitfalls they need to be aware of before pulling the trigger and buying them in an IRA. At the end of the day, a taxable account is still the best place to hold them.

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