Master Limited Partnerships (MLPs) create businesses in which companies are considered to be the aggregates of their partners, rather than separate corporate entities. It might be tempting to include Master Limited Partnership shares, which often pack a solid dividend punch, in your individual retirement account (IRA). But pay attention to the tax implications. In some situations, the benefits of the high dividend can create a tax-filing headache.
Corporations pay taxes on their incomes, and company shareholders pay taxes on the dividends, but MLPs are not subject to corporate income tax. All net income can be passed through to the unit holders of the business, who are personally responsible for the taxes.
Income payments from MLPs do not always generate taxable income. Most are a mixture of net income and a return of capital. The return of capital portion carries no immediate tax liability. Instead, it lowers the tax basis and shifts the eventual tax liability to capital gains when the units are sold. However, MLP units held in an IRA do not receive as much preferential tax treatment. Although income payments can be tax deferred, they will be taxed as ordinary income when withdrawn from an IRA.
Reporting MLP Dividends
Income from an MLP is reported on a K-1 form instead of a 1099-Div. The income received is broken down by category to determine how it should be treated when you file your taxes.
Unrelated Business Taxable Income
The tax code does not allow tax-exempt institutions and retirement funds to defer tax on income generated outside of their core businesses. MLP income payments are considered earned directly by the partners. Because IRAs are not in business to transport natural gas, for example, distributions from MLPs could be considered unrelated business taxable income (UBTI). This makes them immediately taxable. Usually only a portion of MLP income payments are considered UBTI. The K-1 form will split out the taxable portion.
There is a tax deduction for the first $1,000 in UBTI each year from all sources within your tax-deferred accounts. Any UBTI over $1,000 is taxed as ordinary income in the tax year it is earned.
Paying tax on UBTI earned in your IRA does not exempt the income from tax when you withdraw it from your account. Any IRA distribution will still be taxed as ordinary income. The bottom line is that you don't get a tax credit or a deduction for tax on UBTI, and the tax paid does not increase the IRA's tax basis.
Paying UBTI Taxes
Tax on UBTI within an IRA is not paid directly by the account owner. The tax actually is owed by the IRA administrator, who must file the tax return and pay any tax for each account. To make sure your account is credited, mail a copy of your K-1 to the client tax reporting department of the company that holds your account. Some custodians charge a hefty fee for processing UBTI taxes.
Your account can also be liable for taxes in every state in which the MLP does business. Check with your tax adviser, but you don't need to worry unless you're looking to generate tens of thousands of dollars from MLPs inside your IRA.
Avoiding UBTI Taxes
Buying shares in a mutual fund that invests exclusively in MLPs avoids hassles that can accompany owning MLPs in a traditional IRA. Mutual funds and exchange traded funds clear out potential tax-paying headaches. The downside is that you can't chase the MLPs carrying the highest yield.