IRA Account Potential Tax Consequences with High Yield Returns from Master Limited Partnerships
posted Nov 19, 2012 by
Over the last several years with interest rates almost nonexistent for bank savings accounts, finding yield without taking on risk has been a challenge for many people. For those who want to take on some risk, master limited partnerships (MLPs) have become a popular investment. Some of the well known oil pipeline companies that are structured as MLPs are delivering attractive yields in the 5% to 7% range.
Many of these companies trade on the major stock exchanges just like stocks. However, MLPs are not taxed like stocks since these companies are structured as a partnership and receive special tax treatment under the tax code that requires MLPs to distribute 90% of their income each year to investors. For tax reporting purposes, investors of MLPs receive a K-1.
When experienced investors think of investments that generate taxable yield, conventional wisdom indicates that the investment should be held in a retirement account such as an IRA to avoid paying taxable income each year. However, when it comes to MLPs, holding these investments in an IRA can have unintentional tax consequences.
There is a concept in the tax code called “unrelated business income” (UBTI). Tax exempt organizations and retirement accounts such as an IRA must pay taxes on income that is considered UBTI from a business that is not related to their tax exempt purpose.
IRAs that invest in MLPs are considered limited partners in the business operations of the MLP and share in the profits and expenses of the operations. The MLPs’ business is not related to the tax-exempt purpose of the IRA and the income is subject to UBTI, whereas investment income from traditional investments such as stocks and bonds are consistent with the tax-exempt purpose.
The tax code does allow a $1,000 annual exemption before UBTI income is taxed. What this means is if the allocated income, expenses, and depreciation from the MLP is less than $1,000 then no tax is due. If there is any UBTI in excess of $1,000, then the income is taxed at the highest corporate tax rate of 35% and the IRA must file Form 990-T with the IRS.
In some cases, IRAs that hold MLPS may be able to stay under the $1,000 threshold each year and avoid the tax. However, if MLPs are held in an IRA for many years, the year the MLP is sold by the IRA will require the recapture of depreciation taking in past years and the depreciation is recaptured as taxable ordinary income as an ordinary gain. It’s conceivable that the ordinary gain will be in excess of $1,000 that is subject to tax, especially if the MLP has been held for many years.
To avoid any potential taxable consequences within in an IRA, consider having the IRA invest directly in mutual funds (both closed and open funds) or ETFs that invest directly in MLP’s. Income from these investments is treated as investment income.
MLP ownership in most cases are best owned outside retirement accounts since they provide some tax advantages such as tax deferral and the ability to shelter some of the income through depreciation.
KLR Wealth Management works closely with families and high net worth individuals in the Boston market to provide professional services to successful individuals and families. KLR Wealth Management offers assistance with investment advisory services, insurance services, retirement services, estate, gift, trust and succession and tax planning.