June 9, 2010

You Can Hold MLPs in Your IRA

• Dividend Digest Income Insights

Written By Chloe Lutts Jensen

From High-Yield Investing: “One topic that many of you frequently ask me about is Master Limited Partnerships (MLPs). That’s not surprising. MLPs offer some of the best yields around. Even after a large advance in 2010, they carry average yields of around 7%, more than three times the average 1.9% yield of stocks in the S&P 500. Their yields are powered by steady cash flow from services that are always in demand. Most MLPs operate pipelines which ship crude oil, natural gas and other essential fuels. Once the pipeline is built, they have few expenses beyond routine maintenance. As a result, these companies throw off mountains of cash. As well, few regions of the country have overlapping pipelines, so these pipeline operators generally face little competition. Since much of an MLP’s income is derived from fee-based revenues based on volumes shipped, their cash flow is relatively insulated from volatile commodity prices. Most MLPs also have inflation protection agreements built into their rate structures, which further protect their cash flow.

“But the best news for income investors is that MLPs exist to pass along their cash flow as distributions to investors. MLPs must distribute at least 90% of their taxable earnings to avoid corporate income tax. As well, they were designed to distribute most of their cash flow to investors, including both the parent company and public unitholders like you and me. That translates into a steady stream of cash for you. The yield advantage has not been overlooked by investors. The benchmark Alerian MLP Index of 50 major MLPs has seriously outperformed the S&P 500 throughout most recent time periods. Over the past five years, it is up about 16% versus a 9% pullback in the S&P 500; over the past year, it has advanced over 29% versus 22% for the benchmark index, according to Bloomberg data.

MLPs and Taxes

“But 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.”

Carla Pasternak, High-Yield Investing

Tags: Master Limited Partnerships, MLP