Recently I wrote two articles on Master Limited Partnerships (MLP). The first article concentrated on the positive aspects of owning an MLP in a taxable account. In passing I mentioned that MLPs are less well suited in IRA form. Several comments were received that induced me to explain my statement further.
Soon after, I authored a second article with the intent of clarifying some of the very complex tax problems associated with owning an MLP in an IRA.
Quite frankly this started a firestorm. Don’t get me wrong, diverse opinion is the seed of reason. This article commanded so many comments that more and more technical information was required to help the readers “get their arms around it.”
Several readers suggested that yet a third article would be helpful, one that summarized not only the tax issues in the original two articles, but the comments and responses as well. Sort of, “can we see it in one place?” So this article will summarize the previous articles and hopefully provide enough clarity to all. If I err on simplicity, then I refer the readers back to the other articles.
Let’s start with MLPs owned in a taxable account. The tax issue most people are unaware of is the taxation on sale of the units. There is capital gains AND ordinary income. The previous article included reference to IRC Section 1245, but the “doubting Thomas remains.”
Let me close this discussion with a direct excerpt from the FAQ’s from the K-1 instruction sheet of Enterprise Products Partners L.P (EPD).
If I sell my partnership units at a gain, why is part of the gain treated as ordinary income rather than capital gain?
A. A sale of partnership units is treated as if there were a sale of the partner’s allocable share of each of the Partnership’s assets. Gain on the sale of assets for which depreciation or depletion deductions have been taken is treated as ordinary income rather than capital gain. The ordinary income on sale of assets represents the depreciation and depletion deductions previously allocated to you.
Now with that piece of the puzzle settled, let’s move to the IRA issues. The ordinary income cited by EPD is more formally section 1245 income (recapture of depreciation). I mentioned that upon sale of the units, this income is subject to UBTI tax by the IRA.
Readers questioned this on two levels 1) Where does this show up in the K-1? and 2) Where does it show up in the Tax Code?
First let’s look at where this information shows up in the K-1. Most every MLP takes the position that they need only report gross proceeds received on the sale to the IRS. Cost basis, gain, etc. is the taxpayer’s responsibility.
I won’t go into all the reasons for this, but your broker also probably just reports net sales on your entire brokerage account to IRS. A stock by stock basis and gain is supplied in a separate schedule that is not filed with the IRS and is “to help you file your Schedule D return.” This was subject to abuse so starting in 2011 and phasing in over a few years all this changes as basis will now be reported directly to IRS.
The MLP, in the same manner as your brokerage account, and in lieu of reporting the gains directly on the K-1, supplies a separate schedule to assist the taxpayer in computing and recognizing any gain. Of course, you have to actually page through the K-1 package to find all this. It is my guess that many don't look for it, because they don't know they need it.
Each MLP is lightly different, but here’s the excerpt from EPD's supplemental schedule (emphasis added)
If you sold units during the year and EPD has received information regarding such sales, this may be used to calculate your gain or loss from the disposition of units during 2010. First, enter your Sales Proceeds (net of brokerage commissions) in Column 4. Then enter your Purchase Amount (including brokerage commissions) in Column 5. We have provided you with Adjustments to Basis in Column6, which includes cumulative partnership income, deductions, distributions, etc. Subtract the sum of the Purchase Amount in Column 5 and the Adjustments to Basis in Column 6 from the Sales Proceeds in Column 4. Enter this amount in Column 7, Total Gain or Loss. To calculate your Capital Gain or Loss in Column 9, subtract the Ordinary Gain provided in Column 8 from your Total Gain or Loss in Column 7. Please consult your tax advisor.
In short the information is provided but it requires you to calculate the amount of ordinary income (1245 recapture). It is up to you to complete the process and report it to the IRS.
This is probably why so many readers have problems with this subject. They don’t receive the schedule until they actually sell the units. They must then decipher the instruction forms.
When MLPs are required to report basis, the abuses will cease.
Now, that you’ve calculated the amount of ordinary income on your sale, is it reportable to the IRS and subject to UBTI tax?
For those who like to do research the applicable provisions are IRC 1245 and IRC 1250 IRC 512(b)(5) and Treas. Reg. section 1.1245-6(b); 1.1250-1(c)(2).
For those less inclined, let’s look instead to the IRS’ instructions for the UBTI tax return form 990-T, which can be found on the IRS’ web-site. (emphasis added)
Line 4a—Capital Gain Net Income
Generally, organizations required to file Form 990-T (except organizations described in sections 501(c)(7), (9), and (17)) are not taxed on the net gains from the sale, exchange, or other disposition of property. However, net capital gains on debt-financed property, capital gains on cutting timber, and ordinary gains on sections 1245, 1250, 1252, 1254, and 1255 property are taxed. See Form 4797, Sales of Business Property, and its instructions for additional information.
So, even the 990-T leaves room for taxpayer mistake unless you know that section 1245-1255 refers to the recapture of depreciation/depletion that you calculated in the K-1's supplemental schedule.
You see, the tax code, and IRS instructions assume that the taxpayer knows how to navigate.You must first discover what 1245-55 represents, before you see the necessity to bring forward the calculation from the K-1 supplemental. Tax attorneys and CPAs appreciate the complexity, others not so much.
As is often said "Ignorance of the law is no excuse."
Conclusion: It is my hope that by directly showing where the portion of taxable income is reported to the taxpayer by the MLP, how the taxpayer must then “do some minor calculations” and where and why this is included on the Form 990-T much of the confusion will abate.
It is also my hope that those who are not familiar with "tax code navigation" will seek appropriate help from a tax professional. No more "head in the sand."