MLP, UBTI, ETF and IRA: what you need to know
- Unaffiliated Business Taxable Income (UBTI) is the income that can trigger the Unaffiliated Business Income Tax (UBIT) for tax-exempt organizations and retirement accounts.
- Investors can hold MLPs directly in tax-exempt accounts, but may have to worry about UBIT if the UBTI exceeds $ 1,000.
- Investors can hold ETFs that primarily hold MLPs in tax-exempt accounts and not worry about the UBTI triggering the UBTI.
What is UBTI and UBIT? Why is this important for MLP investors and retirement accounts?
Financial advisers and MLP investors have likely seen UBTI or UBIT mentioned in their investment research, but may not fully understand what these acronyms mean. Unaffiliated Business Taxable Income (UBTI) is the income that can trigger the Unaffiliated Business Income Tax (UBIT) for tax-exempt organizations and retirement accounts. In other words, UBTI is income that could be taxed for an entity otherwise exempt from tax. Employee benefit plans and individual retirement plans (IRAs), including traditional IRAs, SEP, SIMPLE, Roth, or Coverdell, are subject to tax on unrelated business income.
Why is this important for MLP investors? Virtually all taxable income of listed partnerships is considered UBTI. Since MLPs are flow-through entities, for tax purposes it is as if the MLP share owner directly earns the income generated by the MLP. MLP businesses, like pipeline operations, are not tied to the purpose of a retirement account that allows them to be tax exempt and therefore the taxable income of an MLP is considered a UBTI. Nothing prevents investors from holding individual MLPs in tax-exempt accounts, but they could incur taxes if the UBTI exceeds the amount of the deduction by $ 1,000. To be clear, taxable income is not the same as distributions or net income. MLP investors can find taxable income on their Schedule K-1.
For investors who want MLP exposure in their retirement accounts but don’t want to worry about UBTI, investment products can help. Exchange Traded Funds (ETFs) that primarily hold MLPs can provide diversified exposure to MLPs and will not generate UBTI because they are structured as C companies. A partnership can generate UBTI, but an ETF cannot . To repeat, investors who own MLP ETFs in tax-exempt retirement accounts do NOT have to worry about UBTI triggering. For those whose eyes may be glassy, ââthe box below summarizes the discussion so far.
Not all that is allowed is beneficial
While investors can hold MLPs and MLP ETFs (for this discussion, MLP ETFs are those that primarily hold MLPs and are structured as C-Corporations) in retirement accounts, this is arguably sub-optimal. . Remember that MLPs offer special tax benefits, including the potential for tax-deferred income. Distributions from MLP ETFs maintain the tax advantages of their underlying holdings, and generally a significant portion of such distributions are tax-deferred. Using a tax-efficient investment in a tax-exempt account is a bit like wearing both a belt and suspenders. Typically, investors only have a limited amount of money in tax-exempt accounts due to annual contribution limits. As such, it would be more optimal to hold investments without tax benefits in tax-exempt accounts. This is why MLP Exchange Traded Notes are better suited for holding tax-exempt accounts. Next week’s note will expand on this and explain more about ETNs.
Alerian is not a tax adviser or an investment adviser. This article does not constitute tax or investment advice. Please consult your tax advisor for information specific to your situation. Alerian’s disclaimers can be viewed here.
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