Why I Bought Linn Energy In My Roth IRA

| About: Linn Energy, (LINEQ)

Linn Energy (LINE) is a widely owned stock favored in part because of its large and growing distributions. Linn and other master limited partnerships (MLPs) have recently come under fire as poor investments for retirement accounts. Many investors know that the sum of all unrelated business taxable income (UBTI) in an individual's retirement accounts cannot exceed $1,000 a year without having to pay taxes. Recently, however, there has been a great deal of discussion about whether selling partnership units in a retirement account requires recapture of previously depreciated assets. In one case, this scenario so scared an investor that he sold all of the MLPs held in his retirement accounts. For many investors, however, a careful consideration of the facts reveals that an IRA is the best place to put MLPs.

Linn Energy Corporate Structure

As a partnership, Linn Energy pays no corporate taxes and instead passes through income and deductions to its unit holders, who include that information on their personal tax returns. Many of these partnerships have good cash flow and pay high distributions, but use high depreciation and other deductions to reduce ordinary income. The distributions received often consist of return of capital, reducing one's cost basis but incurring no income tax. Partnerships like Linn Energy are thus often tax-deferred investments. Tax-deferred does not necessarily mean tax-advantaged, however, and it can easily be detrimental to investors to hold these investments in taxable account instead of tax-deferred (traditional IRA or 401(k)) or tax-free (Roth IRA or Roth 401(k)) accounts.

Linn Energy also has an affiliated stock, Linn Co. (LNCO), whose sole purpose is to hold Linn Energy units. It distributes unit income received, less some fees and some withheld for taxes. The current distribution rate is 71 cents per share per quarter, while that for LINE is 72.5 cents per share per quarter. LNCO also trades at a premium to LINE of 5.6% as of this writing. LNCO, however, reports normal 1099 dividends instead of the more cumbersome K-1 partnership forms sent out by LINE.

Holding MLPs in IRAs

In traditional IRAs, no taxes are due until money is withdrawn, at which point withdrawals are generally taxed at ordinary income rates. Roth IRAs are funded with after-tax dollars and earnings are generally tax-free. MLPs in either type of IRA present the special situation of unrelated business taxable income -- if an IRA has more than $1,000 in UBTI in any tax year, the IRA owes tax. The amount of UBTI is highly variable depending on the individual issue, but I can say that according to the K-1 forms I've received from LINE, UBTI has been zero or negative in five out of six years that I've owned shares. I have therefore been completely unconcerned about UBTI on my LINE shares.

Another potential issue with holding MLPs in IRAs is the possibility that upon selling, recapture of depreciation results in UBTI. There has been significant discussion and disagreement on this issue on Seeking Alpha and elsewhere, and I don't have enough space here to fully describe the debate. It should also be mentioned that this shouldn't be an issue for investors who plan never to sell an MLP. However, for my purposes this issue can be easily avoided: If an estimate of the recapture generated upon sale is total distributions received minus cumulative UBTI, then we can be safe and simply sell a position each time total distributions approaches $1,000.

You might be wondering the wisdom of such a course; after all, won't this generate significant transaction costs? Not really. At forward distribution rates, 100 shares of Linn Energy would take 13 quarters to distribute $1,000. If one were to sell Linn Energy every three years, and pay commissions of say $8 each transaction, then an annualized expense ratio would be 0.14%. In the case of Linn Energy, the LINE units under this strategy are more appealing than the LNCO shares, which do not issue a K-1 but pay a 2.1% lower distribution and trade at a 5.6% premium. Instead of 100 shares of LINE generating $290 in distributions per year, the same dollar amount invested in LNCO would buy only 94.7 shares and generate only $268.95 in distributions annually. Following the safe strategy of selling LINE every three years in an IRA instead of simply holding LNCO would be better by 0.43% annually after all costs.

Why "Tax Advantaged Investments Should Not Be Held in Tax-Advantaged Accounts" Is Bad Advice

Common wisdom holds that tax advantaged investments such as MLPs should not be held in tax advantaged accounts such as IRAs. As a rule of thumb the common wisdom is fine. But tax strategy for your investments need to be tailored to your individual tax circumstances, of which there are as many as there are investors. In many cases, an IRA is the best place to hold an MLP. Consider the following situation:

An investor has $5,000 to invest and has decided that they will invest in Linn Energy. They are currently in the 15% tax bracket, and expect a higher income in the future. Their choices of where to put that $5,000 are: regular brokerage account (pay taxes on income and investment profits), traditional IRA (don't pay taxes on income now, but pay taxes on withdrawals), or Roth IRA (pay taxes on income now, pay no taxes on investment gains).

Whether an investment is tax advantaged or not doesn't change the fact that the Roth IRA is likely the best account for this investor. A traditional account -- suggested by conventional wisdom -- would likely be the worst possible choice for this investor for an MLP, as they defer 15% income taxes now to pay 25%, 33%, or higher taxes when they sell later.

Indeed, in this example, if the investor wanted (e.g., for easier accessibility) to hold Linn Energy in a taxable brokerage account, they would most likely be better off buying LNCO instead of LINE. Fellow Seeking Alpha author Reel Ken had an excellent article demonstrating this point, but the main point is that MLPs defer current dividend and capital gains taxes into ordinary income when sold. When an investor starts and ends in a higher tax bracket, it can take 20 years or more for an MLP to be tax advantageous. If an investor starts in a lower tax bracket and moves into a higher tax bracket before selling an MLP, the investor almost certainly would have been better off holding common stock (LNCO, in this case, even considering the lower distribution rate). Of course, if an investor is in a high tax bracket now but anticipates selling when in a lower tax bracket, the math changes yet again and the MLP may be advantageous.

In any case, conventional wisdom is only a general guideline and in regards to MLPs can easily lead investors astray. I'm neither a registered investment advisor nor a tax professional, but it's clear that investors need to consider their own personal tax situation to determine whether LINE or LNCO is a better investment, and whether it should be held in a taxable, tax-deferred, or tax-free account. For me, LINE in a Roth IRA was the best choice.

Disclosure: I am long LINE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Reminder -- consult a qualified tax professional for information on your specific tax situation.