Investors who need a regular income stream from their portfolio are broadening their ideas of what kind of investments belong in an income-generating portfolio. Most have already realized the potential of dividend-paying common stocks, and many are looking even further afield. One of the highest-yielding investment types we recommend is master limited partnerships, or MLPs.
Master limited partnerships are a unique type of business allowed under the U.S. tax code. They’re similar to a “regular” limited partnership, with a few differences.
In addition to a limited partner or partners, who provide the MLP with capital and get a share of its cash flow in return, MLPs also have a general partner that runs the business.
In addition, Master limited partnerships are publicly traded, by definition. The limited partners are the public shareholders—in this case called unitholders.
The primary benefit of being organized as an MLP is that the business doesn’t pay corporate taxes on its revenue. Instead the cash flow is distributed, almost entirely, to the unitholders (who are then responsible for taxes).
That makes MLPs a very efficient way to pass along the cash flow of an income-generating enterprise to public shareholders. And so they often make large regular distributions and have very high yields.
Carla Pasternak of High-Yield Investing wrote about whether you can hold MLPs in your IRA, and we thought her advice was so incredibly resourceful that we wanted to share it with you.
MLPs and Taxes
Pasternak writes, “There’s one issue with MLPs that subscribers often ask about: Taxes. Recently, subscriber D.S. told me he was nearing retirement. He added that he prefers to hold his income securities in a [U.S.] tax-deferred IRA type of account. That way his dividends can compound without being taxed until he needs to make withdrawals when he retires. After some recent profit-taking, D.S. had about $100,000 of capital to invest in his IRA. He had heard, however, that it wasn’t a good idea to hold individual MLPs in an IRA or 401(k). He wanted to know if that was true, and if so, could I suggest any alternatives ...
Undistributed Business Income Is the Problem
“The short answer to D.S.’s question is there’s no IRS rule against holding MLPs in an IRA type of tax-deferred account. Still, most financial advisors counsel against doing so. Here’s why. Partnerships do not themselves pay corporate income tax. Instead, you as a partner and unitholder are responsible for the taxes the business operations incur. Once a year, typically in March, you receive an IRS Schedule K-1 from the MLP you hold (instead of the more common IRS Form 1099-DIV). This schedule contains your proportional share of MLP revenues, expenses and profits.
“The problem is not in completing the K-1 tax schedule ... Rather, the issue is that as a unit holder, your tax-deferred account is treated by the IRS as if it (and not you) were earning the distributions of the MLP or LLC (limited liability company). Since the distributions have little to do with the business of your tax-deferred account, it’s considered Unrelated Business Taxable Income (UBTI). Each tax-deferred account is allowed a $1,000 deduction on UBTI. After that, UBTI is taxable as ordinary income. That tax bite can reduce returns sharply, especially considering the additional taxes you pay when you withdraw the cash distributions from your account on retirement ...
“Further, if you do go over the $1,000 limit on UBTI, your IRA custodian will need to file IRS Form 990-T on your behalf. The distributions will be taxed at corporate rates since it’s the tax-deferred account that’s taxed, not you personally. Moreover, a typical charge for the paperwork is about $200 for each MLP you own ...
Three IRA-Friendly MLP Investments
“For these reasons, if you own a large dollar amount of individual MLPs, you are best off holding them in a regular taxable brokerage account. But, if like subscriber D.S., you really want to hold MLPs in a tax-deferred retirement account, you have a surprising number of choices—closed-end funds which specialize in MLPs, preferred stock issued by a couple of these closed-end funds, and exchange traded notes (ETNs) which invest in MLPs. Funds, stocks, and debt—these are all asset classes that you CAN hold in your IRA or tax-deferred account. They don’t generate unrelated business income and throw off the type of income that is reported on a standard 1099-DIV form.
“You can choose among a handful of closed-end funds that invest in MLPs. Typically, these funds are taxable corporations and fundholders own stock in a corporation. They send you one 1099-DIV form that reports the income received, instead of multiple K-1s you would get for individual MLP investments. Most funds send out the forms at year-end rather than in March, giving you more time to file your returns before the April 15th deadline. Also, many offer a dividend reinvestment plan, unlike most individual MLPs.
“Generally, these funds provide yields of around 6%- 7%, based on quarterly distributions comprised largely of return of capital. This is not the same kind of return of capital as when a fund has a shortfall of investment income to pay distributions. Rather, it reflects the cash flow distributions of the MLPs in the investment portfolio. Return of capital isn’t taxed in the year received but reduces your cost base when you sell the fund. The difference between your purchase price and the reduced cost base is taxed as ordinary income at your marginal tax rate.”
If you’re considering MLPs or are looking for help generating income, consider subscribing to Cabot Income Advisor or Cabot Dividend Investor today!
What other questions do you have about holding MLPs in your IRA?
*This article was originally published in 2010 and has been updated to reflect current market conditions.