One of the basic concepts of saving for retirement via a retirement plan or Individual Retirement Account (IRA) is that earnings grow tax-deferred until withdrawn. There are certain investments such as Master Limited Partnerships (MLPs) that could result in current income taxation despite being held as an investment within a retirement plan or IRA. Careful consideration should be taken before investing in an MLP.
Publicly traded MLPs make for appealing investment vehicles. They function the same as other publicly traded securities, but they offer the pass-through tax benefits of partnerships.
Individuals who invest in MLPs become shareholders and are then entitled to distributions from the MLPs. These distributions pass through the partnership along with depreciation, which gives them a preferential tax treatment so long as certain conditions are met.
Nevertheless, you should be cautious before using them broadly, particularly with investment in tax-deferred investment plans. Because they share attributes of publicly traded securities, MLPs are permitted benefit plan investments. MLPs may trigger additional requirements for retirement plans however, because retirement plans already receive preferential tax treatment.
If your retirement vehicle invests in MLPs, you should examine your compliance requirements closely to make sure you are not exposing your plan to additional risk.
What Are Master Limited Partnerships?
MLPs are appealing to investors because of the benefits of the pass-through tax treatment. Intangible drilling costs, tax breaks, depreciation and other potential tax-reducers are passed through the partnership to the investor on the investor’s Schedule K-1. This minimizes the taxes owed on the distribution. If a MLP were treated like a corporation, the investors would pay taxes on the distributions from the MLP.
During the late ’80s, MLPs became so popular with businesses that the IRS had to limit their use to protect against corporate tax erosion. As part of the Omnibus Budget Reconciliation Act of 1987, Congress amended the Internal Revenue Code to clarify that MLPs will be considered corporations (and therefore ineligible to use the pass-through tax treatment), unless 90 percent of their income comes from qualifying activities. These activities included exploration, mining, processing, refining and transportation activities related to exhaustible natural resources (oil, natural gas, coal, etc.).
Despite the limitations placed upon them, MLPs continue to be popular and have invoked the need for further clarification on qualifying activities, evidenced by increased issuance of IRS private letter rulings related to MLPs. In 2015, the IRS responded to its increased rulings and proposed amending the MLP regulations to include “intrinsic” support activities to qualifying natural resources activities. The proposed regulations define intrinsic activities as specialized, essential and significant to the qualifying natural resources activities. Broadening the definition of qualifying activities potentially opens the door to more investment opportunities in MLPs.
How are Retirement Plan Investments in MLPs Different?
The benefits to investing in a MLP are not as great if the investor is an IRA or retirement plan. IRAs and retirement plans are tax-exempt, and as such, they have additional requirements to follow related to business activities. The rules are in place so that a tax-exempt status does not give an unfair competitive advantage over non-exempt investors.
Partnership interest, which would include investments in an MLP, qualifies as business activity for tax-exempt plans. Distributions from the partnership interest are considered unrelated business income. This income is also subject to tax at individual income tax rates. It is also a highly scrutinized area of retirement plan activity.
Why are Retirement Plan Investments in MLPs Risky?
Tax-exempt retirement plans and IRAs must report unrelated business income that exceeds $1,000 by filing a Form 990-T, Exempt Organization Income Tax Return. Chances are, any investment in a MLP will trigger the need to file the Form, even after factoring deductions and depreciation passed through from the MLP. Plan organizers may not be aware of the requirement or that distributions from the MLP could trigger tax consequences.
Failure to file a Form 990-T and pay the appropriate taxes could be catastrophic to your retirement plan. Your plan could be penalized or in extreme scenarios, lose its tax-exempt status. When a plan loses its tax-exemption, all of the assets in the plan are treated as currently taxable income to all participants under the plan.
Best Practices
If you are interested in investing in a MLP, it is recommended that you do so outside of your retirement plan or IRA rather than within a retirement plan vehicle. Investors can receive the full benefit without the concern of meeting Form 990-T requirements or finding that their tax-exempt retirement vehicle owes taxes currently.
Retirement vehicles with MLP securities can continue their investments so long as the proper precaution is taken to maintain filing requirements and pay any requisite unrelated business income taxes.
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