My contributions to Seeking Alpha are mostly limited to situations where I feel I have some useful information to share based on my personal experiences as an investor. A combination of events occurring in 2017 in one of my IRAs plus my own growth as a tax practitioner have motivated me to write this article, which I believe sheds some light on this much-debated topic.
Back in December 2011, I authored my first Seeking Alpha article, Should Investors Hold MLPs In Retirement Accounts? Another Perspective. Coincidentally, at about the same time, author Reel Ken produced his thought-provoking (and comment-provoking) article, Master Limited Partnerships And Your IRA. The basic gist of the Reel Ken article was that holding MLPs in an IRA could easily result in Unrelated Business Taxable Income (UBTI) exceeding $1000 when units were disposed of, and represented more tax risk than holders thought they were taking, based on the UBTI figures reported on the K-1 Part III Box 20V. My less-informed opinion (initially) was that a couple or three MLPs in a small IRA, say under six figures, represented a minimal risk of UBTI exceeding $1000 in a tax year. Reel Ken’s article generated an avalanche of comments, and even then, with my minimal income tax knowledge at the time, I responded by modifying my article’s Disclosures Section via Seeking Alpha’s correction procedure, agreeing that there was more tax risk than I had originally supposed. Note that Reel Ken subsequently has authored several articles on MLPs, all of which are very informative, and are available on Seeking Alpha.
A lot has happened for me personally since then. In 2013 I launched into a new second career as an Income Tax preparer, initially focusing on taxes and investments, and I became an Enrolled Agent in 2015. In keeping with my revised opinion regarding MLPs in IRAs, as influenced by author Reel Ken, I have refrained from adding any additional MLPs into any of my IRAs, and have slowly been getting rid of them. But not quickly enough, it turns out. In 2017, in one of my smallest IRAs, with only four MLPs of 100 units each, I breached the $1000 UBTI threshold, and the brokerage filed a Form 990-T, as required. In this particular case, the damage was minimal, in that the brokerage (surprisingly) did not levy a fee for preparing the 990-T, and even though I had UBTI over $1000, I ended up owing no tax, as will be explained later in this article.
Elimination of an MLP Can Occur At Any Time
Energy MLPs have been popular with investors for many years, particularly retirees, with their high payouts. Initially concentrated in the midstream space (pipelines), a number of energy production MLPs were established as the MLP structure increased in popularity. The viability of these production MLPs depended upon oil and gas commodity pricing. The collapse in oil prices beginning in 2014 and extending into 2016 resulted in a number of bankruptcies of these production MLPs. Further, a number of midstream energy MLPs have also been eliminated recently, not all through failure, but by being acquired, or by reorganizing into a C-Corp. One major example is the decision by Kinder Morgan in 2014 to abandon the MLP structure and reorganize as a C-Corp. No matter how it is done, the demise of an MLP will have tax consequences for the partners, certainly in taxable accounts, and possibly in IRAs. Unlike a decision to sell, in the case of a bankruptcy, acquisition, or conversion, the account holder has no control over the timing, and the related tax consequences.
My 2017 IRA situation, whereby a Form 990-T was filed on my behalf by the IRA custodian, provides an excellent case study, in that two of my MLPs were disposed of in 2017. One was intended, via a sale at a significant gain, and one was not, as a bankruptcy occurred, over which I had no control. As will be seen, the other two MLPs in the IRA that were not disposed of in 2017 had a minimal effect on UBTI, illustrating that it is unlikely that UBTI over $1000 will occur from a couple of MLPs in a small IRA unless dispositions occur.
IRA Custodians Vary Greatly in Interpretation and Handling of their 990-T Filing Responsibilities
Before getting into the details of my own situation, I should note that IRA custodians (brokerages) vary greatly in how they address the 990-T filing responsibility. The example I will present represents the maximum situation, in that the brokerage involved fully accepts the responsibility for monitoring the MLPs held in the IRA, and executes this responsibility as thoroughly and completely (and correctly, in my opinion) as possible, based on the information available to the custodian, the K-1s provided by the partnerships, and the purchase and sale information from when units were purchased and sold in the brokerage’s records. I have three other IRAs, all of which have MLPs in their holdings, and none of the others come close to the standard set by the firm in the example. Further research has confirmed my personal experience, in that there are wide variations among custodians in how they deal with the Form 990-T filing requirement emanating from MLPs held in an IRA account. A few observations:
Some IRA custodians do not independently collect the annual K-1 tax packages, but rather depend upon the IRA account owner to forward the K-1 packages to the brokerage. In fact, some custodians do not appear to be doing anything at all, as far as I can tell, to meet the 990-T requirement.
Some only consider the Form K-1 Part III Box 20 Code V value in determining the total UBTI received by the account owner, and ignore the UBTI consequences of a disposition of the MLP during the tax year.
Some net positive and negative UBTI figures each year for different MLPs in the account to arrive at the $1,000 threshold. This is not technically correct, each MLP should stand alone. UBTI losses for an MLP that is NOT disposed of during the year should not be used currently, but rather should be carried forward to later years, and only used upon a total disposition of the MLP in a tax year. One reference stated that there is a 15 year limit on how long negative UBTI values for a given year can be carried forward to be used upon disposition, but I have not been able to confirm this from any other resource.
Multiple references state that the Ordinary Income shown on the K-1 package Sales Schedule, when the MLP has been totally disposed of, is treated as UBTI. This value goes on Form 4797, representing recovery of depreciation on business assets, and then feeds into the 990-T. For an MLP sold, this could easily cause the $1000 UBTI level to be breached.
If the gain is such that there is additional Capital Gain in excess of the Ordinary Gain, it is partially taxable to the extent that the MLP carried debt. The only resource I found that goes further into this topic states the requirement thusly, as paraphrased for clarity: “Partnerships issuing a final Schedule K-1 to an exempt partner that sold its partnership interest should ideally provide additional disclosure detailing the partnership-level highest indebtedness during the 12-month period preceding the date of disposition, and average adjusted basis of the partnership’s assets during that period, to determine the percentage of Capital Gain that is taxable as UBTI”.
To my knowledge, no partnerships provide any information that would allow this percentage to be determined. The brokerage in my real-world example addresses this shortcoming by assuming ANY Capital Gain realized on the final disposition of the partnership (over and above the Ordinary Income reported on the Sales Schedule) is to be treated as taxable Capital Gain UBTI, and is reported on Schedule D of Form 1041, which then feeds into the 990-T. Further, my opinion is that if the Ordinary Income exceeds the total gain, the total of the Ordinary Income would still be reported as UBTI, and the excess of that over the total gain would be a Capital Loss, which would likewise carry to the 990-T via the 1041 Schedule D. This would be consistent with how Ordinary Income and Capital Gain are handled for a disposition in a non-IRA account.
For partnerships being dissolved via bankruptcy, there can be other numbers on the K-1 Form Part III that become reportable UBTI. Two potentially significant possibilities are Cancellation of Debt Income, reported in Box 11 Code E, and losses from dispositions of business property, Section 1231 losses, reported in Box 10. Both of these occurred in the example.
While the K-1 Box 1 income/loss is usually equal to the Box 20 Code V UBTI, occasionally these amounts can differ slightly because of other partner-level deductions, such as Intangible Drilling Expenses or Depletion. Correct reporting here is dependent upon the partnership in preparing the K-1.
To summarize, compliance by IRA custodians with the 990-T filing requirements regarding MLPs has been minimal in many cases, with much confusion as to correct practices. The IRS has apparently just been accepting what they get, and enforcement in this area has been minimal. But this could always change at some point in the future. And even today, if your IRA is held by a custodian that makes a strong effort to comply, as in the example shown, you can experience some unintended tax consequences.
Presentation / Caveats Regarding the Author’s Form 990-T Example
To simplify the presentation, I will present round numbers in lieu of the actual values experienced. Also, even though the example reflects the author’s actual experience, I will refrain from identifying the brokerage involved as well as the specific partnerships. The approach will be to take the partnerships one at a time and discuss what happened, and what was shown on the K-1s. Then, I will revisit each item in the context of the Form 990-T, explaining how each number on the tax form was derived from the K-1 values. Finally, I will present the tax calculation, which in this case was from the Schedule D, and explain why no tax was due, even though there was a small amount of UBTI after the $1000 exemption.
Unrelated Business Taxable Income, No Disposition of Partnership
Just what is Unrelated Business Taxable Income? In the case of an MLP held in an IRA, it is usually the same as the partner’s share of the net income from normal business operations of the business entity, in this case the partnership, as shown on the K-1 Part III Box 1. Specifically, it is the amount shown in Box 20, Code V. As noted, it can be slightly different from the Box 1 value if there are any partner-level deductions applicable, such as depletion. It EXCLUDES various categories of investment income shown on the K-1, such as dividends, interest, royalties, etc.
In recent years, the Box 20 Code V number has been negative more often than not, in the partnerships I have owned. A negative value shown has no effect on the UBTI to be considered for Form 990-T if the partnership was not completely disposed of during the tax year. It will come into play in a later year when the holding is eliminated. This underscores one rule for investors in MLPs – save every K-1 ever received for a given MLP, and retain at least until three years after the due date for the tax return of the tax year of the total disposition of the MLP investment. This rule also applies to buy and sell trade confirmations.
In my case, of the two MLPs that were not eliminated from the IRA in 2017, one had a value of +$10 on the K-1 Part III Box 20V, and the other had a value of -$100. The +$10 value was included in the UBTI total on Form 990-T, while the -$100 value was not used. This is similar to the treatment of publicly traded partnership passive gains and losses on Schedule E when processing K-1s held in a non-IRA account, in that the gains are reported as income, while the losses are suspended, only to be used upon a total disposition of the partnership from the account.
Unrelated Business Taxable Income, Total Disposition of Partnership Sold at a Gain
First, consider the MLP sold at a substantial profit. The 2017 K-1 Part III Box 20V had a value of -$10. The K-1s from prior years had a total of -$180. In this case all of these negative values were included in the UBTI total on the 990-T, since there had been a total disposition of the holding from the account.
The UBTI resulting from the sale at a gain is similar to the reporting of a sale in a non-IRA account. The partnership K-1 package contains a Sales Schedule, with some values supplied by the partnership, and some values to be supplied by the holder from the purchase and sale trade confirmations. The net proceeds from the sale will be the sales amount received, less the sales brokerage commission. In my case it was $3400. The initial basis is the price paid for the units, plus the purchase brokerage commission(s), per the purchase trade confirmations.
Consider my initial cost as $3000. The partnership will supply the cumulative adjustments to basis, which will be a negative value. Consider this as -$2000. When this value is combined with the initial basis, the reduced figure will be an adjusted basis, which as calculated is $1000. Then, the total gain or loss is calculated by subtracting the adjusted basis from the net proceeds, which yields $2400. Next, the partnership will supply a value for Ordinary Income, which is carried to Form 4797 Part II, and also is subtracted from the total gain to get the Long Term Capital Gain, to be carried to Schedule D, Part II. The Ordinary Income in my case was $1800, so the Capital Gain is $600.
In this case, the 4797 and Schedule D (actually, Form 8949, then to Schedule D) are just pass-through forms feeding into the 990-T Part I. Also, note that the Schedule D referred to is the Schedule D associated with Form 1041, Estates and Trusts, not the 1040 Schedule D.
Note that there are numerous complications that arise if the numbers don’t work out so neatly, or if the Sales Schedule has a Section 1250 column, but in the interest of presenting something comprehensible, I won’t get any deeper into it, since they are not applicable to this example.
Unrelated Business Taxable Income, Total Disposition of Partnership from Bankruptcy of Partnership
Since this partnership interest was also totally eliminated from the IRA, the 2017 K-1 Part III Box 20V value is used whether positive or negative. In this case it was a positive $580. The K-1s from prior years for this MLP had a total of -$180, which also is used.
The K-1 Part III Box 10 had a value for Section 1231 Gain/Loss of -$2280, which is not unusual for a failed partnership. It presumably represents dispositions of business property at a loss. This value is carried to Form 4797 Part I, and then to the 990-T.
The K-1 Part III Box 11 Code E value was $1000, which is Cancellation of Debt Income (CODI), which is very likely to occur when a failing partnership is dissolved. This carries straight to the 990-T.
The K-1 Part III Box 13, Other Deductions, had a value for Code J of $5, which reduces UBTI. This Section 59(E)(2) item is usually intangible drilling expense taken at the partner level.
The K-1 Part III Box 20T had a value of $120 for depletion, which is also an expense taken at the partner level.
Thus, the partnership going bust actually helped the UBTI situation overall, thanks to the Box 10 Section 1231 Loss of -$2280.
Form 990-T Part I, Unrelated Business Taxable Income
The Form 990-T total UBTI is developed in Part I of the form. In the example, as shown, UBTI resulted from three sources: Line 5, Income/Loss from Partnerships; Line 4a, Capital Gain from Schedule D; and Line 4b, Ordinary Gain/Loss from Form 4797. I will discuss each line separately, and explain how the values noted above were combined to develop the numbers shown on the form.
Line 5, Income/Loss from Partnerships
This is the sum of several UBTI items from the K-1s, Part III. This is usually just the Box 20V UBTI number, but can also include values from other boxes. For example, often Box 11, Code E will have a significant number in the case of a failed partnership, which as noted is Cancellation of Debt Income (CODI). Line 5 in the example is the sum of the following items:
From Box 20V of the partnership retained which had a positive value for this item, +$10.
Note that the Box 20V value of -$100 shown for the other partnership retained was not used.
From Box 20V of the partnership sold at a gain, -$10.
From Box 20V of the prior year K-1s with negative values, of the partnership sold at a gain, -$180.
From Box 20V of the partnership that went bankrupt, +$580.
From Box 20V of the prior year K-1s with negative values, of the partnership that went bankrupt, -$180.
From Box 11 E of the partnership that went bankrupt, +$1000 (CODI).
From Box 13 J of the partnership that went bankrupt, Section 59(E)(2) deduction of $5. Note that this is not shown as a negative number on the form, but since it is a deduction, it is a subtraction from UBTI.
From Box 20 T of the partnership that went bankrupt, Depletion deduction, $120. Again, it is not shown as a negative number on the form. Same comment as the preceding item applies.
Line 5 total = $10 – $10 – $180 + $580 – $180 + $1000 – $5 – $120 = $1095
Line 4b, Net Gain/Loss from Form 4797
This is usually the Ordinary Income shown on the Sales Schedule from the partnership, which carries to Form 4797 Part II, representing recapture of depreciation taken by the partnership on business assets. A failed partnership will possibly have a negative value on the K-1 Box 10, which is net 1231 loss, which carries to Form 4797 Part I. This occurred in this case, and represents business assets disposed of at a loss by the partnership.
Thus, two entries were made on the Form 4797 in the example, which were combined and posted to Line 4b:
Ordinary Income on the Sales Schedule of the partnership sold at a gain, +$1800.
Box 10 Section 1231 loss on the K-1 for the partnership that went bankrupt, -$2280.
Line 4b total = $1800 – $2280 = -$480.
Line 4a, Capital Gain Net Income
This represents the Capital Gain on a sale of a partnership interest in excess of the Ordinary Income, which as noted represents depreciation recapture, reported by the partnership on the Sales Schedule. The Capital Gain is the Sale Proceeds less the Adjusted Basis less the Ordinary Income. In the example, for the partnership sold at a gain, it is calculated as follows:
Capital Gain = $3400 – ($3000 – $2000) – $1800 = $600.
It is initially carried to Schedule D (associated with Form 1041, Estates and Trusts) Part II, then Part III, then to Line 4a of the 990-T.
The Form 990-T excerpt illustrating Part I is shown below:
Finalizing Taxable UBTI on Form 990-T and Determining the Tax Due
The three (in this example) UBTI numbers are combined to yield total UBTI of $1215. Part II of Form 990-T applies the $1000 UBTI exemption from tax, yielding in this case $215 of taxable UBTI. Part III of Form 990-T Line 36 has two options for calculating the tax due: apply the Trust Tax Rates to the income, or if Schedule D is involved, go to Schedule D Part V to determine the tax. Since some of the UBTI came from Schedule D, this is the applicable choice in this case.
Part V of the 1041 Schedule D is used to determine the tax due. Note that there could be further complications that can require a worksheet in the Schedule D instructions to be used in lieu of Part V, but none of these complications are present in the example.
So the question of how can I have had taxable UBTI of $215 but still owe no tax is answered by following the Part V instructions. The gist of it is that if the Capital Gain component of the original UBTI total (before the $1000 exemption) includes Capital Gain, AND if the Capital Gain is more than the taxable UBTI after the $1000 exemption, AND the Capital Gain is not more than $2550, the lowest Capital Gain tax rate of zero % applies to the taxable UBTI. In the example, $215 is less than $600, so no tax is due.
The Form 990-T excerpt illustrating Part V is as shown below:
Just the headache of trying to understand what could happen should be enough to discourage an investor from holding MLPs in an IRA. But what if, like me, you made this mistake before you knew better, what then? First and foremost, don’t add any new holdings of MLPs into an IRA, nor add to any existing holdings. Also, be sure to hold on to all related K-1s and trade confirmations, and be prepared to make them available to the custodian if needed. My approach has been to gradually sell out of these positions, trying to limit exits to one MLP per year per IRA, to minimize the chances of UBTI exceeding $1000. But if any of your MLPs have gone bankrupt or have been eliminated by acquisition or reorganization during the year, you probably should hold off on any selling until a later year, since you may already have substantial UBTI from events out of your control.
As noted, other than not buying any more, and gradually selling out of these positions, it is out of the investor’s control. If a position has been held for a long time, there likely will be significant Ordinary Income from the sale, even if the share price has not increased, because of basis adjustments from distributions, and other factors.
What about the cost of preparing a 990-T filing? I was pleasantly surprised that no fee was charged in my case. I frankly would expect that a fee of at least $300 would be the minimum, and if a more complex filing with multiple partnerships and dispositions was required, the fee could easily be $1000 or more. That, along with tax due, would definitely hurt. My point is, even though in this one case I escaped any consequences, a larger account with larger positions, and a less benevolent brokerage, could impose a significant haircut on returns. In addition to making a poor investment in the partnership that went bust, I could have been hurt further from having made the mistake of holding MLPs in the IRA, caused by the dispositions of two MLPs in one year from the account.
Disclosure: I am/we are long VARIOUS MLPS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have owned various MLPs in my IRAs over the years, but I am slowly getting rid of them in these accounts, as discussed in the article, for the reasons explained in the article. I continue to own and add to MLP positions in my non-retirement accounts.