Is it possible for your IRA to pay federal income tax?
The type of partnership is a publicly traded partnership (PTP) and more specifically a Master Limited Partnership (MLP). The Internal Revenue Code defines MLPs. The majority of MLPs are in the midstream sector which gathers, processes, transports, and stores oil, natural gas, and distribution of propane and other refined products, coal leasing and mining, and marine transportation of petroleum products.
MLP units differ from corporate stock. The big difference is in how MLP’s and their investors are taxed. Unlike corporations, MLPs and other partnerships are no considered as separate entities for tax purposes. Rather, MLPs and the other partnerships are “pass-through” entities. No tax is paid at the partnership level: partnership income passes through to and is taxed at one level – that of the individual partner.
Since the MLP itself does not pay tax, it is able to pass along more of its earrings to is investors than a corporation.
So the question is can you hold MLPs in your IRA? Yes, but MLPs may not represent the best investment for a retirement plan. First, an MLP offers significant tax benefits that are better utilized in a taxable account. Secondly, an IRA is subject to the “unrelated business income tax (UBIT) after the first $1,000 of net income from a business that is unrelated to its exempt purpose (unrelated business taxable income, or (UBTI). Since an MLP is a pass-through entity, the IRA would be considered to be “earning“ the MLP’s business income, which is almost always considered to be unrelated to the IRA’s exempt purpose. If the IRA’s UBTI from all sources is over $1,000, the fund custodian will have to file a tax return, Form 990-T, and pay tax on the excess out of the IRA’s funds. The tax is calculated at cooperation tax rates which start at 15% and graduate to a maximum of 35%
Therefore, before your IRA invests in any MLP you should give consideration to the magnitude of the income it will generate so that you can avoid your IRA from having to pay income tax.