Avoiding MLP tax risks

Master limited partnerships have become popular investments because they combine the benefits of publicly traded securities with the pass-through tax advantages of partnerships.

Investors in MLPs become shareholders and are then entitled to distributions from the MLPs. These distributions pass through the partnership along with depreciation, which give them a preferential tax treatment so long as certain conditions are met.

But you should be cautious before using them in individual retirement accounts and other retirement plans where earnings grow tax deferred until withdrawn. Because they share attributes of publicly traded securities, MLPs are permitted benefit-plan investments. However, MLPs may trigger additional requirements for retirement plans, because these plans already received preferential tax treatment.

If your retirement vehicle invests in MLPs, examine your compliance requirements closely to make sure you are not exposing your plan to additional risk.

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MLPs are appealing to investors because 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 an MLP were treated like a corporation, the investors would pay taxes on the distributions from the MLP.

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 included exploration, mining, processing, refining and transportation activities related to exhaustible natural resources (oil, natural gas, coal, etc.).

The benefits to investing in an 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 related to business activities. The rules are in place so that a tax-exempt status does not give an unfair competitive advantage over nonexempt 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 a highly scrutinized area of retirement plan activity.

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 an 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 cases lose its tax-exempt status. When a plan loses its tax-exemption, all assets in the plan are treated as currently taxable income to all participants under the plan.

If you are interested in investing in an MLP, it is best to do so outside of your retirement plan or IRA. Investors can receive the full benefit without the concern of meeting Form 990-T requirements or finding that their tax-exempt retirement vehicle owes current taxes. •

Bernard E. Kaplan is a managing director and leader of the Retirement Plan Services Group at CBIZ Tofias, which has offices nationwide, including in Providence and Boston.

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