MLPs for Tax Deferred Acounts

Master Limited Partnerships are very good investment vehicles for individuals looking for high current dividend income. There are some tax issues with reporting MLP income in a taxable account, which led me to explore investing in MLPs through an IRA or ROTH IRA account.

In a taxable account, most of the distributions are considered a return of capital, and thus you do not pay taxes on that portion. This tax deferral does decrease your cost basis however, which could mean higher capital gains or ordinary income taxes if you sell. Because of the supposedly complicated tax returns from MLPs, some investors are shunning MLPs as a class althogether. Others are considering simply purchasing those MLPs in a tax advantaged account, and forget about them.

For non-taxable accounts however, there is a gray area from a tax perspective whether or not one could hold MLPs there. The distributions that an individual that holds a master limited partnership in an individual retirement account receives could be considered unrelated business taxable income subject to taxation. As long as the UBTI from all MLPs in an IRA does not exceed $1000 in a given year, your partnership distributions won’t be taxed.

If the UBTI does exceed $1000 however, the custodian that holds your IRA would have to file a form 990T to the IRS. The tax is paid out of the IRA on the net income from your MLP distributions, which are taxed at the corporate rate.
The UBTI has generally been a non-issue for most MLPs over the past few years, but this isn’t guaranteed. Some like Kinder Morgan (KMP) have even had a negative UBTI in some years, which could be offset against any positive UBTI amounts from other MLPs. Kinder Morgan is one of my Best High Yielding Stocks for 2009.

I do believe however that paying a small tax out of your MLP distributions in an IRA shouldn’t be a big hassle, since distributions are rich and taxed at the corporate rate. One should check with their IRA custodian however in order to asses the amount of fees that the IRA has to pay if the UBTI threshold is exceeded.
If you do not feel comfortable putting ordinary master limited partnerships in a tax-deferred account but feel that you might be missing out, there are still workarounds for this situation. There is an easy way to invest in two MLPs without worrying about taxes too much – Kinder Morgan (KMP) and Enbridge Energy Partners (EEP). They pay their distributions directly as additional shares, which is similar to automatic dividend reinvestment. If you choose to invest in KMP or EEP in an IRA, consider investing in KMR and EEQ.

KMR and EEQ are great vehicles for taxable accounts as well since their distributions are not taxable when received, and thus shareholders are not issued an annual 1099 tax form. You would pay taxes only when you sell your units.
The taxation characteristics of your investments are just one part of the investment puzzle. Always make sure to investigate the company’s fundamentals and do your homework before investing in stocks.

Several publicly traded closed end funds such as Tortoise Energy Infrastructure Corporation (TYG), Tortoise Energy Capital (TTO), Tortoise North American Energy Corp., and Kayne Anderson MLP Investment Company (KYN) provide a proper diversification within the MLP sector. They are suitable for IRAs since they send out Form 1099-DIV instead of K-1, which also makes it easier for investors with taxable accounts to file their annual tax returns. In most cases the dividends received are treated as a return of capital, which reduces your cost basis. In such cases the distributions are not treated as taxable income. Investors would only have a tax liability when they sell their closed end fund.

These closed end funds also do not generate any unrelated business taxable income (UBTI). The main disadvantage of these closed end funds are their steep annual management fees.

Tortoise Energy Infrastructure Corporation has an annual management fee of 0.95% plus a 0.19% charge for other expenses for a total annual expense ratio of 1.14%.Tortoise Energy Capital has an annual management fee of 0.95% plus a 0.25% charge for other expenses for a total annual expense ratio of 1.20%.Tortoise North American Energy Corp. has an annual management fee of 1.00% plus a 0.71% charge for other expenses for a total annual expense ratio of 1.71%.

Kayne Anderson MLP Investment company spots an annual management fee of 2.50% in addition to other fees of 3.40% for a total expense of 5.90%.
Because of high expense ratios, I would think twice before investing in those closed end funds. One thing that is certain in the investment world is that higher fees are not necessarily indicative of superior investment performance. If you cut your costs to the bone, you are much more likely to at least track your index benchmark.

Disclosure: Long KMR

Comments

[Alan Young:]

Wait.... if a company pays all its distributions as additional shares, where do these shares come from? Unless they were sitting on a stockpile of restricted shares, it's just diluting the existing equity by reshuffling the numbers--which is the equivalent of no dividend at all.
So what's the attraction here?

As to closed-end funds, I don't see management fees as a big problem as long as they are small compared to the yield. The problem is that all the funds trade at a premium. If you ever want to sell them, it had better not be when the market has soured on the sector and erased that premium, or you could take a big haircut.

May 31 05:54 PM

[don2m:]

Just a quick note on EEP. I am invested in EEP in an IRA and they pay quarterly in cash and call it return of capital. They do not pay in shares. The last one was last month and they returned 99 cents per share in cash. The yield right now is over 10%.

May 31 08:39 PM

[NoBoB:]

I think the point was that if you're interested in EEP, then EEQ might be an alternative, since it distributes shares, not cash.

May 31 10:58 PM

[realold:]

Good article. I have invested in MLPs through closed end funds for decades and I think your info matches mine. I love FEN , but you have to be patient to get it below NAV - the only point that I would add when comparing CEFs to straight MLP stock, is the premium issue.

May 31 11:44 PM

[User 67133:]

if you have $800 ubti in one IRA and $800 in a second, do you escape the tax or are you taxed on the cumulative amount in your portfolio?
Thanks,
John Gambale


On May 31 05:54 PM Alan Young wrote:

> Wait.... if a company pays all its distributions as additional shares,
> where do these shares come from? Unless they were sitting on a stockpile
> of restricted shares, it's just diluting the existing equity by reshuffling
> the numbers--which is the equivalent of no dividend at all.
> So what's the attraction here?
>
> As to closed-end funds, I don't see management fees as a big problem
> as long as they are small compared to the yield. The problem is that
> all the funds trade at a premium. If you ever want to sell them,
> it had better not be when the market has soured on the sector and
> erased that premium, or you could take a big haircut.

Jun 01 09:30 AM

[Thesmothete:]

Lower fees, together with diversity, in AMJ.

Jun 01 10:54 AM

[Old Trader:]

Just a quick observation on KMR; they typically only pay in "whole share" amounts (i.e. if the dividend were to equally 3.7 shares, the 3 shares are PIK...that is additional shares, while the .7 share amount would be paid in cash).

Disclosure: long KMR and MMP.

Jun 01 11:21 AM

[Robert Moyat:]

Do you know what the tax status is of distributions from AMJ - regular income vs. partnership income? This is a new ETN, and I haven't been able to determine this issue. Thanks.


On Jun 01 10:54 AM Thesmothete wrote:

> Lower fees, together with diversity, in AMJ.

Jun 01 11:48 AM

[Mr Gadget:]

How does Linn Energy (LINE) fit in here? They pay in shares (to the best of my info).

Jun 01 11:50 AM

[prairiedog555:]

when I look at ETF Connect I see much higher management fees for TYG TTO and TYN.

Jun 01 11:51 AM

[barry kraynack:]

What are your thoughts on ENY?

Jun 01 12:08 PM

[d_teller:]

To "User 67133"

The Unrelated (to) Business Taxable Income (UBTI) limit is per TAXPAYER ID, across all tax-sheltered accounts (Roths, SEPs, IRA's ,401K's), etc. The K-1's go electronically to the IRS from the Fiduciary of the Business (The MLP, HOLDR. Commodity trading Index maker, such as Deutsche Bank for the DBA & others)...and the tax payer , NOT the IRA's fiduciary, gets a paper copy.

The tax-payer has to notify one of the sheltered accounts' fiduciary to prepare a IRS form 990t (and the brokerage or investment house legal dept. will send forms to be filled out and charge a fee to be paid from proceeds of that shosen IRA account for the cost of preparing a Tax-Shelter's Tax Identification Number [990t is a TIN registration form])...and then the data needs to be sent to that TIN issuer, and that Fiduciary will pay the UBIT (Unrelated Business Income Tax) to the Federal Govt.

This process can take some weeks, and always occurs after the due date for income taxes. The tax-payer can't pay directly...it would be after the fiscal year end, and be considered an "excess contribution" for the IRA.

The fees can range upwards of $200.00, and are similar to those that are used for "Self-directed IRA's" that may hold commodities, rental property and other investment real estate, collectibles and prcious metals.

The only forms the regular IRA's file to the Feds are the 1099R's and the 4698 "end-of-year" statements of contributions, sales and withdrawals.

There are a whole slew of Closed End Funds that handle all the vexatious paper work (and part of their high fees are the costs to do this), Kayne Anderson has KYE, KYN, etc. Tortoise has TYG...and others, which MAY be held in a sheltered account. Wait to invest until they trade at a significant discount to NAV, which is usually when commodities are being dumped or decreasing in value (which occurred last Fall, see "Robert Young"s comments, above).

It is best not to hold a K-1 generating security in a sheltered account, nor a Grantor Trust, such as GLD or SLV, nor a commodity fund that states that it might take physical possession of the commodity (DBA, for example), since these aren't allowed in the usual sheltered accounts.

To "Robert Moyat",

ETN's have recently been classified by the Treasury Dept., as "Bond" type investments, since they are debt offerings from an investment group. Their "interest" payments or "dividends" are considered as marginally taxable dividends. They MAY be held in sheltered accounts.

Jun 01 12:22 PM

[Ozarker:]

What?

Jun 05 12:08 AM

[W0rthy:]

In an ad for an MLP newsletter, they mention a Greece based shipper that was an MLP and paid no UBTI, making it suitable for a tax deferred account. Can anyone either tell me what that shipper would be, or point me to some resources on MLPs where could find it listed?

Thanks,

Jul 18 01:11 PM