Having just purchased shares (units) of NuStar (NS) in an IRA, I once again find myself reflecting on this much-discussed, seldom-clarified topic. In this article I will offer what I have learned and what I believe to be a reasonable approach. Before I begin, in the interest of full disclosure, note that I am not a financial professional nor am I certified in any way as a tax advisor. On the other hand, I have done my own taxes for the past 45 years, have spent many hours in tax research, and have always striven to do my taxes so correctly that I need have no fear of being audited, which so far has never occurred. (When that day comes I will share what I learn with the world – and I suspect I will be more humble!)
Also before I begin, I want to mention a couple of excellent resources for the reader who wants to know more. The National Association of Publicly Traded Partnerships website has a lot of excellent information on MLPs, including a section on the topic of holding in IRAs. Another reference that I found useful was a website for Miller-Howard Investments, Inc., which I originally located with a Google search on the topic. I am sure there are many other resources out there. Plus, there is always the IRS website, where you can spend many happy hours reading and reviewing the relevant publications and forms.
The short answer to the above question is yes, you certainly can hold MLPs in an IRA. There is nothing in the IRS rules for IRAs that says you cannot. However, many if not most financial advisors say you should not, for two reasons:
First, since MLPs are tax-advantaged investments, the investor is effectively wasting this benefit by holding in an IRA since the IRA is tax-advantaged also.
Second, and this is the more serious objection, if the investor realizes more than $1000 of Unrelated Business Taxable Income (UBTI) from all MLPs held in a single IRA account, the excess will be taxable (even though it is in an IRA).
Let me take these one at a time, beginning with the easy one, the first. As an investor holding shares (actually, units in MLP-speak) of an MLP, you receive dividends (which in the case of MLPs are actually termed distributions), but at tax time (for regular, taxable accounts), you do not report these distributions as income. Instead, you receive a K-1 form from the MLP which details your share of income, deductions, credits, and a host of other items. You use the K-1 values in completing various IRS schedules and forms, which may include: E-Supplemental Income and Loss, D-Capital Gains and Losses, B-Interest and Ordinary Dividends, A-Itemized Deductions, 4952-Investment Interest, 4797-Sales of Business Property, 6251-Alternative Minimum Tax, and maybe more. To help you with this task, you receive detailed instructions from the MLP for using the K-1. After all is said and done, you usually (maybe always) end up paying a lot less than if the distributions received were reported as dividend income. As with all matters involving the IRS, it is not a totally free lunch. The distributions received serve to reduce your cost basis in the holding, and when you sell, the IRS (theoretically) will get to tax you on a larger capital gain. None of this matters if you hold the units in an IRA. Like all gains and positive money flows inside an IRA, you will pay tax on withdrawals at your normal ordinary income tax rate at the time of the withdrawal. Hence, you are “wasting” the MLP tax benefits. To this I reply, “Let me waste as much as I want,” when I am getting a distribution at a 7% to 8% yield, compared to a typical corporate dividend yield of 2% to 3%.
Now let us move on to the really tricky issue, the risk of UBTI exceeding $1000 for a tax year in a single IRA account. To understand this, you need to be aware of the mechanics of how this is supposed to work. Your IRA custodian, presumably a brokerage, should request that you send them all K-1s that you have received for all MLPs held in your IRA at that brokerage. The brokerage should determine, based on the K-1s, whether the UBTI total from the K-1’s exceeds $1000, and if so, should complete IRS form 990-T, which is roughly similar to Schedule C, in that it allows for business income and related expenses to arrive at a taxable amount. Then, if tax is owed, the custodian, not the account holder, pays the tax, drawing funds from the account holder as needed. Even if you can see from your K-1s that UBTI is nowhere near $1000, you (theoretically) should forward your K-1s to the brokerage anyway, because losses in one year supposedly can reduce the 990-T taxable amount in a future year. Even if it is determined that tax is owed, it is not a violation, and there is no penalty – just some tax due. One caveat is that the brokerage may levy a significant fee for their trouble, which if so should factor into your total return calculation. For individuals with significant retirement funds desiring to hold a lot of MLPs in their accounts, avoiding the $1000 threshold could be an argument for having multiple accounts, since the $1000 limit is per account, not across all IRAs an investor has.
Another clarification is needed as to what qualifies as UBTI? For the custodian (brokerage), which is the entity actually considered to be the “partner” which is liable for reporting the UBTI, it is effectively all of the partnership’s income allocated to the units the investor holds in the account. This is bourn out by inspecting a couple of K-1’s that I have from last year, whereby line 1 on the K-1, Ordinary Business Income (Loss), is the same as line 20, item V, UBTI. Regarding whether UBTI can suddenly mushroom from prior year recapture when an MLP is sold in an IRA, as a recent Seeking Alpha article by contributor Reel Ken suggests, I believe it is fair to say that this is not settled. Further, it is very difficult to find any information on the topic that goes beyond the basics. I believe that small (low six figures) accounts with only a couple of MLPs are unlikely to be affected either way, while large (high six figures and beyond) accounts with substantial MLP holdings certainly could be impacted. They might realize UBTI in excess of $1000 even without any selling any MLP holdings. As in most areas of finance, size matters.
Now that’s the theory, here’s the reality. I have five separate IRAs which have held MLPs off and on through the years, and only one (Schwab), has ever requested that I send in my K-1s. I did not send them in because the UBTI was nowhere near $1000, and in fact has been negative for some years, and far less than $1000 in other years. I suppose I should send them in if negative, to receive a benefit in the future if I have positive UBTI, but in fact the probability is so remote, I have not bothered with it. Based on my experience from owning several MLPs in multiple accounts over the last few years, an account with 100 to 300 units each of a couple of partnerships would be very unlikely to have UBTI over $1000 in a given year.
There are other, unrelated reasons not to go overboard on MLPs. Since these are usually energy-related, owning too many could lead to over-concentration in that one sector. Another remote possibility is if the IRS provisions should happen to be changed (or even if a whisper of a change should be overheard in the hallowed halls of Congress) to reduce or eliminate the tax benefits, MLP unit prices would likely drop substantially. (Recall the “Halloween Massacre” of 2006 when the Canadian government announced the end of favorable tax treatment for Canadian Trusts.)
Before I conclude, I want to discuss briefly my own MLP holdings and investing experience with MLPs, and current recommendations. As a retiree searching for yield, I went into MLPs significantly in 2007 & 2008, still smarting from the Canadian Trust debacle. (I actually came out OK on the trusts, although I did see some paper profits evaporate.) Like a lot of my earlier moves, I “didn’t know what I didn’t know.” I then learned all about K-1s, UBTI, and so on. So my first suggestion to an investor contemplating an MLP is to learn all about the tax ramifications before proceeding. Based on what I now know, I personally am avoiding MLPs in my taxable accounts, because I don’t want the additional burden they impose at tax time. (Hence my interest in the subject of this article.) My results with MLPs have been very good, but certainly would have been better if I had not sold “too soon”, a propensity I am working to correct. MLPs have become much more popular the past few years, and the prices reflect that fact. Some of the most popular MLPs are trading today at prices that are in many cases higher than they have ever been. I believe that many if not most MLPs (at least those I would like to own) cannot be bought today with any “margin of safety”, even though they represent successful, profitable businesses. An exception (to pricing, not business profitability), is NuStar, which I mentioned at the beginning of this article, which I purchased just this week. A tabular summation of my MLP holdings and investment experience is presented below:
To summarize, I believe that a solid business organized as an MLP is an acceptable holding in an IRA, with the caveat that the investor should take care to avoid exceeding the $1000 UBTI threshold in a tax year. For me as an investor, the yield has to be 7% or more for an MLP (in any account, taxable or tax-deferred) to be attractive. When units of successful partnerships can be acquired at prices that allow for a yield above 7%, I will consider buying.
Additional disclosures: Based on my review of an article by Seeking Alpha author Reel Ken entitled, “Master Limited Partnerships and Your IRA”, along with the extensive comments, and other research, I have requested that the following selection from my later article on MLPs, “Yield, Value, Safety And Complications With MLPs”, be added to this original article on the topic by myself, as an Additional Disclosure. My purpose is ensuring that my more enlightened views on the topic are made clear to readers of either of my articles.
In it (the Reel Ken article referenced), the author made a case for the risk of a substantial increase in UBTI upon sale of units that had been held for some time inside an IRA. The impact could be significant, such that an investor that, prior to selling, had little risk of exceeding the $1,000 UBTI threshold, could suddenly and unexpectedly be over the threshold. The article generated a huge number of comments, and the author has responded extensively with thoughtful, reasoned and supported responses. My advice is to read the article and every last one of the comments before deciding whether you agree with the central point of the article, or not. By way of clarification, I must point out that I also have an article out on the topic, which I wrote just before the Reel Ken article came out. In it, based on the published resources I had relied upon, I stated that I felt that small investors with small MLP positions in their IRAs did not need to be concerned with UBTI. I have since come around to agreeing conceptually with Reel Ken that this is an exposure. It very well may become more of a concern in future years, as the IRS pursues tax compliance and revenue enhancement ever more aggressively. I concur that for all but the smallest accounts, the UBTI risk on sale of units should be considered.