Investing in a publicly-traded Master Limited Partnership (MLP) can be a savvy move for some investors. This is because the MLP, unlike a common or preferred stock, is taxed as a partnership. In doing so, the earnings of the MLP are distributed to its members on a Form K-1, instead of through dividends or capital gains. What's even better is that most MLP's make a distribution on a regular basis. This distribution might appear to be a dividend, but it is not, because the taxpayer is paying tax on the earnings, not the distribution. Here is an example:
Randy owns 100 units of ABC MLP, a publicly-traded partnership. The taxpayer receives four quarterly distributions of $100 each, for a total of $400. At the end of the year, Randy receives a K-1 from ABC which shows $50 of ordinary income. On Randy's tax return, he will report $50 of passive income on his Schedule E. The $400 from a tax perspective is basically forgotten, to be deposited into Randy's brokerage account for other investments or reinvested in more units of ABC MLP.
MLP's are also commonly known to have high distribution yields, such as in Randy's situation above. He received $400 of cash during the year for his investment, but only had to report $50 on his tax return. How do they do it? Many MLP's take advantage of tax deductions such as depreciation and domestic production activities in order to reduce their taxable income below their book income. These deductions are not cash expenses, which allows the MLP's to distribute high amounts of cash even though their taxable income is low. Good for the MLP, and good for the investor.
Because of their high distribution yields, many investors choose to hold MLPs in their retirement accounts. From a tax perspective, this is where the situation gets a little dicey.
Retirement accounts, such as IRAs and 401(k)s are technically considered tax-exempt entities. There is a little known rule that if these entities earn something called Unrelated Business Taxable Income (UBTI) over a certain threshold, they are required to report that income to the IRS and pay tax. The threshold is $1,000, and the tax rate is 39.6% (gasp)!
Let's go back to Randy, and now he owns 5,000 units of ABC MLP in his IRA. He receives $20,000 in distributions during the year, and his IRA receives a K-1 with $2,500 of ordinary income. The IRA is the partner in the MLP, not Randy, so the IRA will have to file a Form 990-T and pay tax of $594 ($2,500 - $1,000 exemption = $1,500 x 39.6% = $594). It is not Randy's responsibility to file this return; the custodian of the account will do the filing and use money from the IRA to pay the tax. This scenario shows how a tax-savvy investment in a tax-exempt account just became taxable.
In summary, individuals that hold MLPs in retirement accounts should monitor their positions to ensure that they are not losing any of their retirement savings to taxes. Those that are interested in making significant investments in publicly-traded MLPs should consider doing so in taxable accounts, the main reason being that the individual tax rate will most likely be lower than 39.6%.