Master Limited Partnerships (MLPs) have grown in popularity in recent years due to their strong income yield, preferred tax treatment, the American energy production boom, and, more recently, a Trump administration friendly towards the energy sector. They also tend to have low correlations with most other asset classes, making them a strong diversifier when used within a properly allocated portfolio. Unfortunately, they also come with tricky tax treatment, especially when held in an IRA, making caution warranted.
Simply put, MLPs are Limited Partnerships that can be publicly traded on exchanges like a stock. A big advantage to this business structure is that they don’t pay income tax at the entity level; rather that tax is passed through to the investors based on their ownership portion. In order to qualify as an MLP the business must earn at least 90% of its income from “Qualified Sources” which are namely activities relating to natural resources or real estate. The most common examples of MLPs are businesses that build and operate energy infrastructure, such as oil and natural gas pipelines, storage facilities and refineries. The business must also distribute all income in excess of operating costs to its owners, which is what creates the strong cash flow that many investors find appealing, particularly given the low interest rates available in the bond market. This income also creates a complex tax situation that few investors are aware of.
Just as income will be passed on to investors so too will liabilities and expenses, including partnership expenses and depreciation, which investors can use to offset some of the income generated on their taxes. That means that often as much as 80-90% of the quarterly income distributions from direct ownership of an MLP will be treated as a return of capital, meaning that investors don't have to pay income taxes right away on that money. Instead, that portion of the distribution simply lowers the owner’s cost basis in the product. Remember that cost basis is what you paid to buy the product, and that capital gain taxes are paid only on the value above what you paid on an investment upon its sale. Therefore, when dealing with a taxable account, you are effectively putting off the tax bill on the income you are getting from the product until you sell the MLP.
Once your cost basis reaches $0, then most of the income that was treated as Return of Capital and any price appreciation would be taxed as Long Term Capital Gain, while certain amounts that were written off for things like depreciation would be recaptured and taxed as Ordinary Income. The details of each year’s distributions will be reported to owners via a form K-1, which can make tax time a bit more complicated as the details of each distribution will need to be tracked for proper tax reporting down the road. Be sure to consult your tax advisor when considering the use of individual MLPs in your portfolio.
Many people seek to simplify the tax situation by holding individual MLPs inside a tax qualified account, such as an IRA or a Roth IRA. While there’s no regulation that prohibits this, it may not be a wise idea. First, you’re adding a tax advantaged asset into an already tax advantaged account, therefore wasting a tax benefit by taking the spot of other assets that could have benefited if they had been held in the IRA with those funds being used to buy the MLP. Even more importantly, holding an individual MLP in an IRA may trigger an unexpected tax bill from Unrelated Business Taxable Income (UBTI). (I.R.C. §§511-514)
UBTI results when a non-taxed entity, such as an IRA, 401(k), or 501(c)(3) charity, generates revenue through a business line that is unrelated to their exempted purpose. As an example, imagine a school that operated a business selling widgets for a profit. Selling widgets has nothing to do with education,
so the profits would be taxable to an otherwise tax preferenced entity. When your IRA invests in an MLP it becomes a limited partner in that business and, since MLPs are a pass through entity, your IRA is effectively earning a share of the business income. The tax code considers that income to be unrelated to the retirement account’s purpose, saving for retirement, and therefore becomes taxable. The actual amount of UBTI would be reported on the annual K-1 document. Thankfully, the first $1,000 of aggregate UBTI in the IRA is exempt from taxation, and not all MLPs spin off UBTI each year, but anything beyond that will be taxable.
Technically, it will be the IRA that owes taxes once the aggregate level of UBTI exceeds $1,000, not the IRA owner. Therefore, you won’t pay the taxes as part of your normal 1040 filing, but rather the IRA will pay the taxes out of IRA assets by submitting a form 990-T to the IRA’s custodian. The custodian will actually file and pay the taxes for the IRA. What’s more, IRA tax brackets work off the same marginal rates as trusts, which are far more condensed than the personal rates and are listed in the table below:
￼As you can see, it doesn’t take much before the IRA gets to the top tax bracket. Fortunately, the IRS grants investors some relief in that there won’t be a 10% early distribution penalty on the taxes paid out of the IRA if the owner is under age 59.5, as it isn’t the owner’s distribution.
Despite all of the complexities, the MLP space can be an attractive addition to a well-diversified portfolio for the reasons already discussed. So how does one get exposure to this asset class in their qualified accounts without triggering this little known area of the tax code? Exchange Traded Funds (ETFs), Exchange Traded Notes (ETNs) and Open and Closed End Mutual Funds can give investors exposure to diversified portfolios of MLPs, rather than individual MLPs, without having to worry about generating UBTI or, in some cases, even having to deal with a K-1. These are also complex securities and involve their own risks and tax structures which should be discussed with both your Financial Advisor and your Tax Advisor prior to use, but are certainly an option for those looking to pick up exposure.