MLPs - Yes, They're Okay In Your IRA And Other Tax Questions Answered

by: David Stein


It IS okay to hold MLPs in your IRA or 401k.

It may be more complicated to hold MLPs in taxable accounts.

Don't let tax "complexity" dissuade you from owning MLPs.

Investors searching for more income may want to consider MLPs. They generally offer higher yields than 'traditional' companies. Because their distributions are mainly tax deferred, the 'Conventional Wisdom' says that its best to hold them in your taxable account. If you have read my other articles like this one, then you know I offer some contrarian views for you to consider. So this article will discuss the advantages of holding an MLP in your IRA, and some disadvantages to holding it in your taxable account. That being said, I am writing this article based on the fact that I have owned MLPs in my taxable and IRA accounts for many years. Also for the past 15 years I have worked as a tax preparer for HRBlock and have consulted with other preparers and prepared tax returns for clients that own MLPs. My clients are "typical" individual investors and not family trusts or other large entities.

There have been many articles on MLPs and just the other day this excellent one discussed the Kinder Morgan family of investments and some of the tax issues. My article is just a follow-up to that, and perhaps to give you something else to think about. Hopefully it will clarify and simplify some issues and not make the subject more confusing.

Quickly, rather than being a shareholder, as in a corporation, you are a partner in a business. A shareholder records his dividends on the tax return. If there are no dividends, then there is no tax entry until you sell the stock. As a partner (unitholder), you share in the profits, losses, credits, deductions, interest, dividends etc. And ALL of that is entered on your tax return each year. That's why you get that pesky K-1 instead of the 1099.

Objections answered about MLPs in IRAs:

That pesky K-1: You get the K-1 when you have the MLP in your IRA/401k, but it is not an issue because you don't have to make all those entries. Your tax return is simpler. Likewise, when you sell, you do not have to report any profit or loss or other issues.

It's a waste to hold tax-advantaged equities in an account that is already tax advantaged: That may be not be true. All things being equal, don't you want that higher yield? Even if it IS better in your tax account, that doesn't mean you should not hold it in your IRA.

The Dreaded UBTI: What's that? Certain income that if more than $1000 in a year MAY be taxable even though it is in your IRA. (You see that in box 20-V). How do you calculate it? You don't. The custodian of your IRA figures it out. So if your UBTI was $1100 for the year, you might owe $25 or so. What are the chances of this happening? Just about 0%. These number are almost always negative. I have never prepared a tax return that had an amount over $1000. Last year the UBTI for my KMP was (-) $4502. Only one of my 4 MLPs had a positive number. ARLP was $159 on a position value of about $30,000.

Disadvantages of holding MLPs in your taxable account: Although the distributions in a taxable account are tax deferred, you may get annual interest, dividends, or taxable gains from sale of property (box 9 or 10) these are usually small, but could add to your taxable income. Again, this is not an issue in your IRA.

Finally, while those distributions are tax DEFERRED, they come back when you sell. Each year your basis is decreased, eventually to 0. When you sell, all those deductions may be taxable as ordinary income (not long-term gain). Again, this is not an issue in your IRA. Also, if you own the MLP long enough in your taxable account and your basis is 0, then the distributions will be taxed as ordinary income each year.

Conclusion: Conventional Wisdom says that you should not hold MLPs in your IRA. But it is not that "black and white." If you have money in your IRA that you want to invest, and want a higher return, then consider MLPs.

Conclusion #2: C-Corp alternatives like LNCO: Linn Energy (LINE) recently offered investors a C-corp alternative -- LinnCo (LNCO) -- that may simplify the issues for many investors. You get the high yield without the issues. I am in the 15% bracket. This year I sold all my LINE from my taxable and IRA accounts and switched to LNCO. My dividends in the taxable account will not be taxed and I won't have to worry about tax issues down the road. In my IRA I still get the high yield. Next year I will report on what tax issues come up in my taxable account and whether UBTI is an issue when you sell in your IRA.

Disclosure: The author is long KMP, ETP, ARLP, LNCO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.