And The Final Twist (For Now) on Non-Traditional Assets Within IRAs: What Does One Do With a Master Limited Partnership In An IRA?

• IRON100
• February 5th, 2010

As driven by the request of our own Barrie Abalard, I decided to tackle the question of the suitability of Master Limited Partnerships within Individual Retirement Accounts (IRAs), whether they be Traditional IRAs or Roth IRAs.

This answer will be shorter than most, as there are some things you will need to check with your tax professional (in this case, an experienced tax attorney or an experienced Certified Public Accountant (C.P.A.).  The reason that they seem a bit out of place for an IRA comes from the income these assets spin off and because of the fact that income taxes are already deferred by the very nature of MLP structure. They are designed to throw off losses and income over time. Still, they might (not always but MIGHT) have a place in a tax-deferred portfolio. If they are significantly undervalued and throw off revenue, then they probably do deserve a place in an IRA (particularly a ROTH IRA if that cash can be funneled into other investments within it).

A decent definition of a Master Limited Partnership (MLP) is shown here. MLPs are basically publicly traded units of a business partnership that invests in natural resource development, energy exploration and production, and real estate for example.Two of the most notable of these MLPs would be Blackstone Group (BX) and Kinder Morgan Energy Partners, L.P. (KMP). Clearly the formerly uninitiated now know what L.P. stands for. (Don't make me stare you down if you don't).

Traditionally (and this is true for real estate ventures within IRAs, NO money can be contributed or withdrawn from an IRA to pay for an investment that exists within the IRA. What that means is only capital that exists WITHIN the IRA can be used to fund the ventures if the IRA is to keep its tax-deferral status. That can have two implications:

1) As long as investment contributions and returns for each partner can be descretely defined and accounted for, then, if BOTH partners partnership assets are contained WITHIN an IRA, the IRAs can partner with each other. This has happened in several circumstances where individuals might not each be able to own commercial property within an IRA, but two or three COULD. But again remember that ALL of those assets must be accounted for from INSIDE the IRA. No, and I mean NO assets can come from non-tax deferred sources (like out of one's pocket for example). That is why one needs an IRA administrator for this kind of self-directed IRA account to manage the paperwork under these circumstances. The Internal Revenue Services loves to wreck tax-deferred partnerships every chance it gets, because their paydays (including fines) can be enormous.

2) Because of that fact, it is critical if NOT ABSOLUTELY VITAL that you have both a skilled IRA custodian AND a taz attorney or CPA review any such tax-deferred structures for soundness. Note, I did not say avoid them. What I mean to say is that you CAN make these structures work, but one must be able to DEFEND it to the IRS with proper legal documentation and proper accounting of revenues and expenses.

What I just discussed abovee was a simple partnership that two substantial IRAs did to manage real estate. An MLP is divided into individual units of ownership. They are legally allowed by the Internal Revenue Code (IRC) to distribute their income as return of capital and as such is ALREADY tax deferred. The reason it is tax-deferred is that investors keep not only the revenues but also any passive losses that the MLP spins off during normal activities each year. The capital gains and losses are shown in Form K-1 and the dividends are reported on Form 1099-DIV

For tax deferred accounts that produce income, there is a bit of a sticky rule that must be dealt with. According to the Internal Revenue Code, some of the income an MLP throws off can be considered "unrelated business taxable income" or UTBI (love those Congressional gibberish-like acronyms). As long as UTBI does NOT exceed $1,000 per year, those distrubtions will NOT be taxed within an IRA.

What happens if it DOES exceed $1000 annually. Two things:

1) It has to be taxed at the corporate income tax rate of the MLP (which each one tracks) and you, the unit holder of the MLP, are required to pay it.

2) Your self-directed IRA custodian will have to file a form with the IRS called Form 990T and pay the tax at the corporate tax rate that the MLP is required to pay. In that way, any income in excess of that $1,000 will be paid according to the Internal Revenue Code.

If that is the way your MLP pays its gains and income, then you must deal with that paperwork rigmarole. Is there a way to avoid such procedures? Indeed, there is. Here are some ideas:

1) Invest in MLPs that pay their distributions in SHARES. Kinder Morgan Energy Partners (KMP) and Enbridge Energy Partners  (EEP) come to mind. Share distributions are not considered taxable events in this case, so no paperwork or other administrative gyrations are required.

2) There are numerous MLPs that pay their dividends through Form 1099-DIV. Those forms do not require the UBTI designation and the Form 990T filing. From this article, there are a number of MLPs shown that pay dividends only.

CONCLUSION:MLPs are, by nature (and by design after the Tax Relief Act of 1986) a tax-deferred investment. Because one can write off the losses as the gains begin to be reaped, they really do not belong in IRAs under most circumstances. However, if they are substantially cheaper than the net value of their assets (and at times many are), and it throws off income at a nice clip, one might be foolish NOT to consider placing one within your IRA asset mix.

Just understanrealize that certain portions of the income must be taxed outside the IRA (like UBTI for example). To avoid that, one can invest in MLPs that issues dividends as shares, or which provide their income in dividend payments. That action alone will keep paperwork much simpler than with traditional MLPs.

Realize, however, that unless the MLP is cheap on an intrinsic real asset value basis and pays a decent income stream, there are better candidates in all likelihood to meet your investment return goals for retirement. There are lots of likely better suited investment alternatives if one does one's homework.  As always, check with your tax professional (in this case, either an experienced lawyer or C.P.A.) to work through the suitability of the investment and the tax strategy which is being used to maximize the ultimate value of that investment.

Tickers: EEP, Form 1099-DIV, Form 990T, Individual Retirement Accounts, KMP, Master Limited Partnerships

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