Summary
- Directly owning MLPs can generate Unrelated Business Taxable Income (UBTI) for tax-exempt organizations and retirement accounts.
- MLP ETFs will not generate UBTI, but they still may be suboptimal for tax-advantaged accounts.
- MLP ETNs and RIC-compliant midstream ETFs tend to be well suited for tax-advantaged accounts.
Investors often have questions about owning Master Limited Partnerships (MLPs) or MLP investment products in retirement accounts. Admittedly, there are some nuances around this that could be easy to overlook. This note discusses potential issues for tax-exempt organizations and retirement accounts owning individual MLPs, and alternative ways to get MLP exposure in these accounts. This commentary is not intended to serve as tax advice, and investors are encouraged to consult with a tax advisor for guidance specific to their situation.
Individual MLPs in Retirement Accounts.
MLPs are pass-through entities that enjoy special tax treatment due to their involvement with natural resources. Notably, MLPs do not pay federal income taxes at the company level (MLP Primer here).
Investors can own individual MLPs in their retirement accounts if they want, but it is generally suboptimal for two main reasons. First, MLPs can generate Unrelated Business Taxable Income (UBTI) for tax-exempt organizations and retirement accounts (read more). As pass-through entities, it is as if the owner of the MLP units is directly earning the income generated by the MLP. The MLP’s business function (pipelines, storage, etc.) is not related to the purpose of an entity or account being tax exempt. As such, practically all the taxable income from an MLP is considered UBTI, which is reported in the MLP’s Schedule K-1. An investor could incur taxes if UBTI exceeds the allowed $1,000 deduction. Owing taxes for a tax-exempt entity or account is clearly not an ideal outcome.
MLPs’ tax advantages are another reason to potentially avoid owning them in retirement accounts. Owning a tax-advantaged investment in a tax-advantaged account can be considered a waste. It’s a bit like wearing both a belt and suspenders. Typically, investors would want to own tax-advantaged investments in taxable accounts, so they can own investments without special tax treatment in tax-advantaged accounts.
What about MLP Funds and Products in Retirement Accounts?
If an investor wants MLP exposure in a retirement account without having to worry about UBTI, investment products can help. MLP ETFs will not generate UBTI, while providing a 1099 tax form, instead of a Schedule K-1. That said, MLP ETFs retain some of the tax advantages of their underlying holdings (read more). As such, investors may prefer to own MLP ETFs in a taxable account.
Typically, an MLP ETN is best suited for a tax-advantaged account. Otherwise, the coupon from an MLP ETN would be taxed at ordinary income rates. An ETN is not expected to generate UBTI. More broadly, there are some elements of uncertainty around tax treatment for MLP ETNs, which would also incentivize ownership in a tax-advantaged account or by a tax-exempt entity. While investors can find more information around tax treatment for MLP ETNs in their prospectuses, consulting with a tax advisor would likely be best.
RIC-compliant midstream ETFs, which can only own up to 25% MLPs, are also suitable for tax-advantaged accounts. They will not generate UBTI, and because MLPs have a smaller weighting, RIC-compliant funds typically provide less tax-deferred income. Therefore, RIC-compliant ETFs are not “wasted” in tax-advantaged accounts.
Bottom Line:
For tax-advantaged investors, individual MLPs can potentially generate UBTI and possible tax headaches. However, accessing the MLP space through investment products like ETFs or ETNs can avoid UBTI for tax-exempt entities or retirement accounts.
Related Research:
MLPs and MLP ETFs: Not Just Income, but Tax-Deferred Income
MLPs, UBTI, ETFs, and IRAs: What You Need to Know
Accessing MLPs/Midstream Through ETNs
Energy Infrastructure Council Commentary on MLPs and Retirement Accounts
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