A Master Limited Partnership (MLP) is a publicly traded partnership (PTP) that sells individual “units” of its limited partnership interest on public security exchanges just like corporate stocks. Although it trades much like a corporate stock, MLPs are often focused in energy and natural resource related businesses (due to tax code requirements). MLPs also pass out their income and expenses to partners on a Schedule K-1 instead of paying tax directly like a corporation. In addition to passing out the income and expenses on Schedule K-1, the partnership will distribute cash that, instead of being taxed as a dividend like corporate stock, will not be taxed at all (unless these distributions lower the adjusted basis in the MLP below zero or the units are sold at a gain). Because of the above mentioned benefits and the diversification these investments can provide, it may be advisable to own units of PTPs; but for reasons discussed below, they may not be appropriate investments to own in retirement accounts.
One reason to not invest in a PTP through your retirement account is that MLPs take advantage of tax-deferred distributions of cash and are able to offset taxable income on the Schedule K-1 with other deductions being reported. Because a retirement account is already tax-deferred, these benefits are not as significant as they would be to a currently taxable entity.
Another reason, and perhaps the most compelling, is that MLPs may trigger unrelated business income tax (UBIT) within the retirement account causing more compliance issues (filing of IRS Form 990-T and any state equivalent) and potentially tax to be owed. UBIT is the taxing of trade or business income generated in a normally tax exempt entity (retirement plans are considered tax exempt trusts). Going back to the above, investing in a “unit” of a MLP makes the owner a limited partner in the partnership resulting in the retirement account to be treated as “earning” the share of the MLPs business income. If the retirement account is invested in a PTP that is involved with natural resources, it is now treated as “earning” income related to natural resources, considered trade or business, which causes unrelated business taxable income (UBTI).
The filing threshold for IRS Form 990-T is $1,000 or more of the entity’s gross (gross receipts minus any cost of goods sold, this does not include expenses related to the income) UBTI. An area of concern here, is that when the MLP reports their income and deductions on Schedule K-1, they may either not report the UBTI or they will report the net UBTI (filing requirements are triggered by gross income not net income).
If the retirement account does trigger the UBIT filing requirements, it is not the responsibility of the account owner to file the necessary returns and pay any taxes associated, but it is the responsibility of the custodian or trustee of the account. This may result in the custodian or trustee being unaware of any required filing and taxes, or if they are aware could entail more fees for the account in order to have the necessary returns filed and taxes paid. Failing to file returns could result in large penalties and interest associated with past due balances that could be seized out of the retirement accounts assets.
It is essential to talk with your retirement account custodian to make sure they are aware of the necessary filing requirements and also to discuss the pros and cons of holding MLPs in your account. It is also important to speak with your tax advisor regarding the rules surrounding the possible repercussions of UBIT in your retirement account as they are often the most informed about rules and regulations surrounding tax issues. If you have questions or concerns, feel free to contact our office directly.