I don't intend to start the MLP-IRA-UBTI fray all over again, but rather, to discuss the IRA investor's options in this area. Essential to understanding the choices, is first, to understand the obscure tax issues surrounding MLPs and IRAs.
When an MLP is sold, a portion of the proceeds is reportable as ordinary income and a portion is capital gains. The ordinary income portion represents a recapture of depreciation and depletion allowances, the so-called section 1245,1250 recapture. In an IRA, this recapture is subject to UBTI tax and in most cases can easily exceed the $1,000 threshold for reporting and paying UBTI Tax. In fact, in many cases it will approach the total amount of distributions received over the years. This can be quite substantial.
Most IRA owners of MLPs find this astonishing as they never heard or believed such a tax was imposed when they sold their units. First, UBTI tax is reported on form 990-T. This is the applicable excerpt from the IRS instructions for form 990-T.
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
There seems to be three schools of thought on this.... 1) I don't care what the IRS says, I don't believe it, 2) I'll avoid this mess by avoiding the sector and, 3) I'll invest in ETNs, ETFs or CEF (closed end funds) instead.
I'm not a big fan of ETNs to begin with and have expressed my reasons, in depth, in a prior article. So, let me concentrate on ETFs and CEFs, for now.
Certainly an ETF or CEF avoids the complexity of issuing a K-1 to the IRA and exposing the IRA to UBTI tax. They also offer diversification. Now, diversification is a good result, but does K-1 simplicity really accomplish anything worthwhile?
Both the ETF and CEF pay the tax that would otherwise have been paid by the IRA. So instead of the IRA paying the tax, the IRA's net investment return suffers. Some CEFs, such as Nuveen Energy MLP Total Return Fund (NYSE:JMF) actually deduct from the NAV a set aside reserve for future anticipated taxes, including 1245 recapture. The day-to-day returns, therefore, are appropriately accounted for, but the IRA could suffer compared to outright ownership of the MLP, depending upon timing issues. At least JMF is not leaving the investor with a false sense of value.
Another consideration is that tax rates, which are graduated, make it possible, if not likely, that the tax paid by large pooled asset funds could be at a higher rate than an isolated IRA would pay.
For the "nay-sayers", those that don't believe the IRA pays tax, the ETF or CEF is a "slap in the face". By owning these funds, the "nay-sayer" ends up paying a tax, albeit indirectly, that they don't think they would otherwise have to pay.
Now don't get me wrong on MLPs. I think their steady and somewhat conservative income stream are well suited for IRAs. I think a little more perspective would be helpful.
Though the MLP unit-holder pays a tax, the MLP itself does not. If the investment was in a typical stock, a "C" Corp, the Corporation would pay a tax. Corporate tax suppresses its earnings and balance sheet. So, one could argue that the valuation and earnings of an MLP are greater than their twin Corporate counterpart and that this should be reflected in a increased share price or distribution rate.
Assuming a rational, "invisible hand" market, the MLP should trade, proportionally, for more than the non-MLP, all other things being equal. After all, the UBTI is intended, not to be punitive, but, rather to be an equalizer.... equalizing MLPs and "C" Corps.
That means that even the MLPs (such as Kinder Morgan) that offer "C" Corp. shares don't escape the inevitability of these taxes. Though the market has yet to realize the equivalency of KMI and KMP, they should. When this happens they should trade, after considering taxes at every level, with equivalent ROI.
So, in the end, I really don't think the MLP tax issues over-ride the benefits a MLP may afford. And certainly, I wouldn't go into a CEF or ETF just to avoid this tax, but rather for diversified exposure. My advice is as it always is,.. research and choose the best investment you can for the goal you are trying to achieve. Taxes are the price you pay for picking a winner.
Conclusion: Though no one likes to pay tax, the IRA investor must keep in mind that any business they invest in, if profitable, will have a tax imposed on its earnings. So, instead of maneuvering to avoid an inevitable tax, take that effort and choose a good investment. In many cases, it may well prove to be a MLP.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.