June 14, 2013
Written By Chloe Lutts Jensen
A few weeks ago, I wrote here about investing in master limited partnerships, or MLPs, and invited you to send in your questions about owning MLPs. (You can read the original article here if you missed it.) The tax issues surrounding these high-yield investments can get pretty complicated, so after receiving your questions, I turned to one of our Dick Davis Digest contributors for help.
Bob Carlson is the editor of Bob Carlson’s Retirement Watch, and is an expert on all the financial aspects of being retired, from investing to estate planning to tax issues. He originally trained as a CPA and attorney, planning to become a tax attorney and adviser, but a knack for writing for a broad audience led him into the publishing business. While writing for a newsletter called Tax Avoidance Digest, he noticed that he got a lot of questions from people looking to take money out of their IRAs—and he couldn’t find a good, accessible source of information to point them toward. As he says, “There were IRS regulations, but they were long and difficult to read.” (Which is exactly why I turned to him for this information.)
So he decided to fill the gap himself, and founded Retirement Watch in 1991. The newsletter filled the void Bob noticed by providing accessible, accurate information on using your IRA—and he offers a useful report, the IRA Investment Guide, which curious non-subscribers can download from his website here. In addition, Bob thought his readers would be interested in broader information about all the financial aspects of retirement for his readers, so Retirement Watch also provides advice on investing, reducing income taxes, estate planning, long-term health care, Social Security and Medicare, and more.
Bob does a good job making these often-complex topics accessible to ordinary investors, so I thought he’d be a good expert to consult about your MLP questions. He was happy to help, and his answers to your questions are below. Our first question comes from a reader named Dave (although a few others sent in the same query).
Question from Dave: Great info, but I do have a question. How do MLPs work in a Roth IRA as you pay no tax on these accounts?
Bob Carlson: Roth IRAs are subject to all the rules of traditional IRAs, unless the Roths specifically are exempt in the tax law. In the case of unrelated business taxable income (UBTI) and MLPs, Roth IRAs do not have an exemption. So a Roth IRA that owns MLPs or other investments that produce UBTI could owe income taxes.
Question from Peter: Will you let me know if owning REITs in my Roth IRA has the same problems (“unrelated business taxable income,” or UBTI) as discussed for MLPs in an IRA?
Bob Carlson: No, there are no special issues when you own a REIT in your Roth IRA or other qualified retirement account.
Question from Ed: Thank you for the explanation of MLPs. Would you clarify the state tax liabilities? Might I get into a situation of having to file many state income tax returns as a result of owning an MLP with operations in many states?
Bob Carlson: That’s certainly a possibility. Here is the language from the 10-K form filed with the Securities and Exchange Commission by Enterprise Products Partners, L.L.C., the largest of the MLPs:
“In addition to federal income taxes, our common unitholders will likely be subject to other taxes, such as state and local income taxes, unincorporated business taxes and estate, inheritance or intangible taxes that are imposed by the various jurisdictions in which we do business or own property even if the unitholder does not live in any of those jurisdictions. Our common unitholders will likely be required to file state and local income tax returns and pay state and local income taxes in some or all of these various jurisdictions. Further, they may be subject to penalties for failure to comply with those requirements. We may own property or conduct business in other states or foreign countries in the future. It is the responsibility of each unitholder to file its own federal, state and local tax returns.”
On the bright side, most states have de minimis levels for filing the income tax returns. Most investors who own some MLPs in a diversified portfolio aren’t likely to trigger the filing requirements. But you should check to be on the safe side. Most MLPs try to be shareholder-friendly and include as much explanatory material with their annual tax statements as they can without actually giving tax advice.
Question from John: I am able to currently do my income taxes myself. Are the rules so complicated on MLPs that I would require professional help to do my taxes? Can you expand or give examples of what tax forms would be required and if the rules are so complicated that I would not be able to do them myself?
Bob Carlson: MLPs require some forms with which most investors aren’t familiar, but they aren’t very difficult or hard to understand. The MLP will send you an annual K-1 instead of a 1099-DIV or similar form. The K-1 lists your pro-rata share of each income and expense item of the partnership. You likely will report these items on Schedule E, instead of the Schedule B where payouts from stocks, bonds, and mutual funds are reported. If your state has an income tax, it likely will require you to either complete similar state versions of the form or attach a copy of the federal forms to your state return. As stated in my answer to a question above, you might have to file returns in more than one state, depending on the operations of the MLPs you invest in, the extent of your investments, and the different state laws.
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Question from Chris: Thanks for trying to explain MLP taxes! I own units of Enterprise Product Partners and Energy Transfer Partners. Two questions:
1. If a K-1 for 2012 shows a business loss (opposite of taxable net income), interest income, dividend income and a capital gain, do you report all of these items on your 2012 tax return or the year when you sell the units or some items in 2012 and the rest when sold?
2. I understand that distributions are taxable when you sell the MLP. For an MLP held for more than 1 year, are the distributions treated as short-term capital gains and the remaining gain treated as long term capital gains?
Thanks for your help. I called both companies and they are not very helpful answering these tax questions.
Bob Carlson: In general, you report on your tax return for the year each item of income and expense listed on the K-1. Many MLPs accompany the K-1 with some guidelines or instructions that indicate where on the individual tax return each item should be reported. You might not be able to report a business loss on your tax return, because you aren’t an active participant in the business. The loss would be suspended until it can be offset by either future income or gain from the sale of the units.
Taxes on the sale of an MLP are more complicated. A large portion of MLP annual distributions aren’t taxable because of depreciation or similar write offs. The nontaxable portion of distributions generally decrease your basis in the units. Long-term holders often have the tax basis of their units reduced to zero. In that case, all “gain” from the sale of the units is ordinary income, not capital gain. Here’s how Enterprise Products Partners explains this in its 10-K form:
“If a common unitholder sells common units, the unitholder will recognize a gain or loss equal to the difference between the amount realized in the sale and the unitholder’s tax basis in those common units. Prior distributions to a unitholder in excess of the total net taxable income a unitholder is allocated for a common unit, which decreased the unitholder’s tax basis in that common unit, will, in effect, become taxable income to the unitholder if the common unit is sold at a price greater than the unitholder’s tax basis in that common unit, even if the price the unitholder receives is less than the unitholder’s original cost. A substantial portion of the amount realized, whether or not representing gain, may be ordinary income to a unitholder. In addition, because the amount realized may include a unitholder’s share of our nonrecourse liabilities, a unitholder that sells common units may incur a tax liability in excess of the amount of the cash received from the sale.”
Question from Scott: I appreciated your article on MLP’s. My question pertains to the UBTI in an IRA. Where and how is this reported to the IRS?
And a related question from Forrest: Thanks for the article about MLPs. In January, 2013, I invested in three MLPs within an IRA account. The account has now received MLP distributions of about $1,150. You mentioned that distributions above $1,000 will trigger a UBIT liability.
1. Is the UBIT liability only on the amount in excess of $1,000?
2. What is the UBIT tax rate?
Bob Carlson: An IRA is most likely to be taxed when it earns what the tax code calls unrelated business taxable income (UBTI). The UBTI rules apply to all qualified retirement plans, not just traditional IRAs. If an IRA earns gross UBTI exceeding $1,000 it must file a Form 990-T and pay income taxes at the corporate tax rates. An IRA also must pay estimated income taxes during the year if the tax is expected to exceed $500. The return is filed by and the taxes are paid by the IRA, not by the owner, and the custodian or trustee of the IRA is supposed to be responsible for filing the return and paying the taxes from the IRA. But the custodian might not receive the Form K-1 reporting the income or might not file the return.
Be sure to check with your custodian and coordinate who is responsible for filing the form and paying the taxes. Most trustees and custodians will charge the IRA for filing the return. You can obtain Form 990-T and the instructions on the IRS web site at www.irs.gov.
The $1,000 limit applies to the IRA, not to each investment in the account. If all the UBTI earned by the IRA during the year exceeds $1,000, the tax obligation is triggered. Also, the $1,000 limit applies to the IRA, not per taxpayer.
When you have more than one IRA, each IRA has its own $1,000 UBTI limit. The IRA owner essentially will be taxed twice on UBTI. The IRA will be taxed on the income. Subsequently, the owner or beneficiary will be taxed on distributions of that income. There is no deduction or credit available for UBTI paid by the IRA and it is not added to the tax basis of the IRA.
Wishing you successin your investing and beyond,
Chloe Lutts Jensen
Editor of Investment of the Week