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Question re tax owed on MLPs held inside an IRA

edited April 16 in Other Investing
Here’s a quote that prompts my question:

“The IRS allows IRAs to have up to $1,000 worth of UBTI in them. More than that – and your IRA will owe the tax. The custodian of the account will file a special 990-T form and pay what is owed via assets from the savings vehicle. Typically, they’ll drain any cash holdings first, but if that isn’t sufficient, they will sell various stocks, mutual funds, ETFs and even the MLP itself in order to have the IRA pay the tax. Depending on how the custodian agreement is written, you may have little say on what they choose to sell.” Source

Strictly interpreted, this seems to say that once an IRA has accumulated more than $1,000 worth of UNTI, than all of them become taxable annually on into infinity.

Do they really mean …

(A) more than $1,000 during a single tax year ?

(B) only the amount over $1,000 (is subject to tax) ?

Both of the above would make a big difference in a decision whether or not to own a MLP inside an IRA.

Additional concern: Would additional (UBTI) paperwork still need to be submitted to IRS by the MLP holder even if the UBTI has not exceeded that $1,000 limit?

I’ve read a lot on this and understand the reasoning behind owing taxes on on IRA holdings of “pass through” investments. Just unclear of what that $1,000 exemption really means. Thanks for any clarification - perhaps from personal experience.

Comments

  • The $1,000 exception is on filing the Form 990-T (an annual income tax form), not on the amount taxed (if the form is filed). So: (A) yes, (B) no.

    Since the exception is on the filing and not the tax, I think that addresses your additional concern in the case that the MLP holder is an IRA trustee/custodian.

    I'm not clear about what you find special regarding pass throughs in IRAs. Mutual funds are pass throughs. REITs are pass throughs. The income from these pass throughs is deferred (or in the case of Roths, exempt) until distribution.

    Form 990-T instructions state (under "Who Must File") that IRA trustees must file if the trust (IRA) has more than $1,000 in income. The only entity listed under "who must file" that isn't given a $1,000 exception is a college or university of a state of other governmental unit. Othwerwise, either there is no filing requirement of the MLP holder or the holder gets a $1,000 filing exception.

    An additional reference is CCH that writes:
    "An IRA is subject to the unrelated business income tax if it receives unrelated business taxable income in excess of $1,000 per year.¹
    ¹ IRC §408(e)(1); Reg. §1.408-1(b); Ltr. Rul. 9703026, citing IRC §§408(e)(10, 511, 512(b)12."

    If one is really set on holding MLPs in IRAs and there is the possibility of exceeding the $1,000 filing threshold, why not simply split the holding between two or more IRAs?
  • edited April 16
    Thank you @msf

    - Re “I'm not clear about what you find special regarding pass throughs in IRAs. Mutual funds are pass throughs. REITs are pass throughs.”

    My (evolving) understanding is … with a traditional corporation the entity has already been subject to / paid taxes at the corporate level. With MLP’s they have not. (See citation below.) You are, in effect, legally part of the corporation, and hence, responsible for paying tax.


    - Re “If one is really set on holding MLPs in IRAs and there is the possibility of exceeding the $1,000 filing threshold, why not simply split the holding between two or more IRAs?”

    That’s an interesting thought. Fortunately, I think, the investment would be small enough that I’m quite confident the dividends paid out over one year would not reach $1,000 based on the MLP’s history. Dividends are paid quarterly so there would be ample opportunity to monitor and adjust.


    - Interesting article (linked by @msf) re mutual funds. I suspect most managers avoid MLPs not wanting to add tax complexity.


    - The MLP would be purchased thru Fido like a stock or fund and so there’s some assurance of support from them should it become necessary. It is encouraging that the $1,000 applies to each tax year and is not carried into future years which would cause one to exceed that threshold. But, if I understand correctly, exceeding the $1,000 limit by even $1 would lead to taxes being owed on all $1001 of the UBTI. (Doesn’t seem fair)


    *Here’s a relevant citation: “Due to the way MLPs are structured, these entities usually don't pay corporate taxes. MLPs avoid the standard double taxation problem that regular C-corps have, in which the company pays tax on its net income that funds the dividend, and then investors have to pay their own tax on that dividend.” Source
  • msf
    edited April 16
    hank said:

    - Re “I'm not clear about what you find special regarding pass throughs in IRAs. Mutual funds are pass throughs. REITs are pass throughs.”

    My (evolving) understanding is … with a traditional corporation the entity has already been subject to / paid taxes at the corporate level. With MLP’s they have not. (See citation below.) You are, in effect, legally part of the corporation, and hence, responsible for paying tax.

    That's an explanation of why pass throughs, such as sole proprietorships, partnerships (including MLPs), S corps, and mutual funds are taxed at the owner level. But it doesn't say why pass throughs are special in IRAs.

    Unrelated business income tax was created so that non-profits did not compete unfairly with for-profit businesses. Think of colleges. They may run their own businesses on the side, businesses that have nothing to do with their non-profit mission of educating students. If those side businesses fell under the school's non-profit umbrella, then they'd have an unfair advantage over their for-profit competitors. Thus, UBTI is identified and taxed when run by non-profits.

    Put these two concepts together - passing income taxation through to the investor and taxing non-profits for running businesses on the side. What you come up with is non-profits and other tax-favored owners (such as IRAs) getting taxed on UBTI of the pass through entities (e.g. MLPs) they own.

    See, e.g. https://www.wec.cpa/media-hub/does-your-organization-have-unrelated-business-income
    hank said:

    Fortunately, I think, the investment would be small enough that I’m quite confident the dividends paid out over one year would not reach $1,000 based on the MLP’s history. Dividends are paid quarterly so there would be ample opportunity to monitor and adjust.

    Divs are a mix of return of capital (ROC), regular income, and UBTI. So UBTI is only a part.
    hank said:

    - Interesting article (linked by @msf) re mutual funds. I suspect most managers avoid MLPs not wanting to add tax complexity.

    What I was trying to convey was just that mutual funds are themselves pass through entities. So what you were describing (about how pass throughs' income had to be taxed at the owner level) applied equally to mutual funds as o MLPs.
    hank said:

    But, if I understand correctly, exceeding the $1,000 limit by even $1 would lead to taxes being owed on all $1001 of the UBTI. (Doesn’t seem fair)

    Somewhat like a bank not reporting $9.99 of interest but reporting $10. Though you're supposed to pay tax on that either way. Another analogy: Medicare premiums - increase your income by $1 over the threseholds and you'll have to pay a sizeable IRMAA surcharge.
  • @hank,

    Just to clarify, it’s not the amount of distributions from the MLP, it’s only the amount of UBTI that MLP produces. And some years, MLPs produce negative UBTI (or so I have heard from past holders in various investment boards). You may already know this, but it wasn’t clear from your second post. Apologies if you already knew it. Cheers!
  • edited April 16
    @Graust, I think we’re on the same page. Some of these MLPs crank out double-digit interest (through dividends). Seems to be a big part of their appeal. That’s the part Some of that that may get passed through and not taxed at the corporate level. Capital appreciation, if any, is a separate matter and not affected by the regulation as far as I can tell. Whether income from dividends = UBTI I’m uncertain - but likely the case.

    Thanks
  • edited April 16
    @msf said “Divs are a mix of return of capital (ROC), regular income, and UBTI. So UBTI is only a part.”.

    That’s very encouraging. It the very high income distribution from some MLPs that led to my initial concern / question. From your comment it sounds like the UBTI would likely represent only a portion of the total dividend payout - so I can’t see where a modest investment in one of these would lead to tax issues in my case.

    The point re non-profits is understood.

    Wow! The discussion and knowledge gleaned here far exceed my original part A and B question. Thank you for the replies.
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