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I recently wrote an article on the Investor's View of Master Limited Partnerships (here). The article had an extremely high interest level and many readers chose to add comments. Many of the comments/questions involved whether or not MLPs are well suited for IRAs.

There were a number of comments that weren’t all in concert with the tax problems associated with MLPs. It seems best to devote this article to a more in depth discussion.

The problem in including an MLP in an IRA is based on a section of the IRS Code (Section 512(a)(3)) that can impose taxes on entities that are otherwise tax exempt. This is commonly referred to as Unrelated Business Taxable Income-UBTI. This tax would include entities such as an IRA or Roth (even pension and Keogh Plans). Before I go into the MLP specifics, it might be of help if we discussed what this section is about.

Let’s say your local Church regularly runs a Cake Sale to raise money. After doing this successfully for a while the Church decides to open a bakery and make even more money. They hire staff and even though all the profit goes to the Church for its good work, they are in the “bakery business”. Now, a bakery business is quite different than a cake sale. The IRS took the position that regular engagement in a business gives tax-exempt entities an unfair advantage over for-profit business and introduced UBTI to even the playing field. They did so by imposing a tax on the earnings, even though they would accrue to the Church. This tax is imposed on tax-exempts that regularly engage in a business (with some exceptions that aren’t relevant to this article).

When an IRA buys units in an MLP it becomes a partner in the MLPs business. Though the units may be a very small minority interest, it is an interest nonetheless. As a result a proportionate share of the MLP’s net earnings are taxed to the IRA. There is a $1,000 annual exclusion that helps somewhat.

Many readers that have MLPs in their IRAs noted that they don’t seem to have much of an income to report. As a result they conclude it is not so much of a problem. That conclusion does not tell the whole story. Let’s look a little closer.

Let’s say that $25,000 is invested in an MLP. The distribution (return of capital) is 6% per year ($1,500). This is not subject to UBTI as return of capital is not taxable income. Now, the MLP does make money from its operations. The net income represents a “pass-through” to the unit holder. Your share of the gross income might be $5,000 and your share of cash expenses (salaries, interest, etc.) might be $3,500. So far, the share of the net income is $1,500. This is before application of certain accounting adjustments.

You won’t see this $1,500 reported on the K-1 as net income subject to UBTI. That’s because the MLP has some “accounting tools”, namely depreciation, depletion allowances and similar tools that further reduce currently taxable income.

Assuming these “tools” provide another $1,400 in expense deductions, your taxable earnings are reduced to just $100. It is this amount that is reported on the K-1 and is within the $1,000 annual limit.

Unfortunately, there is a catch. This additional $1,400 is recaptured when you dispose of the units and classified as ordinary income. That means that though the current MLP earnings are shielded, the “shield” is taken off at disposition and all previous earnings that were shielded are now brought back in as ordinary income. It is this income that is now subject to UBTI.

Let’s say that you held your units for 10 years and the MLP had $15,000 in earnings. Of those earnings $14,000 was shielded by these “tools” and is now subject to recapture.

Let’s say that you then sell the units for $35,000. In your mind you have a $10,000 capital gain which is not taxed to the IRA.

In fact that’s not how the IRS tallies the transaction. They would consider $14,000 as “recapture” subject to ordinary income and therefore UBTI. Only the balance is either capital gain or cost basis and not subject to tax. If you now withdraw these after UBTI-taxed amounts from your IRA they will be taxed again. This is not the result most people would want.

Whether anyone decides on including an MLP in their IRA is a choice only they can make. It is important that their choice be an “informed choice” and so they need to be aware of the possibility of current AND/OR deferred tax obligations. The investor should not be swayed just by the current K-1 because it doesn’t tell the whole story.

Additional note: Though this article focused on the UBTI issues in an IRA, the same tax issues exist for MLPs in taxable accounts. That is, on disposition of the units, your sales price will include ordinary income, capital gains and cost basis recovery.

Source: Master Limited Partnerships And Your IRA