SeekingAlpha writer JD Welch wtites of a special UBTI recapture tax that can come into play when a MLP is held and sold within a IRA. I have not found any information on this from any creditable source(SA is not creditable). Any information? Sounds like a possable short ploy.
I normally don't get involved in the MLP/UBTI/IRA debate because it gets ugly really fast. But my tax season hasn't really started yet. So if you're interested, keep reading. This is the first of 3 posts that I post from time to time.
You wanted to know, with citations, whether the ordinary gain on the sale of an interest in an MLP is UBTI.
You aren't going to find a specific ruling from the IRS. Mostly because it isn’t needed, although I would have thought that the IRS would have issued some specific guidance on MLPs by now, considering how popular they have become.
To find out whether it is taxable for UBTI purposes, there are 3 steps you need to go through (with cites as I go).
First, what does the ordinary income as shown on the K-1 attachment represent?
Second, how does the IRS treat the individual components of the ordinary income amount for UBTI purposes?
And third, is there anything special about the fact that the gain is recognized through the sale of a partnership interest (as opposed to direct ownership of the underlying assets)?
So first, what does it represent – IRC Section 751(a) provides that gain on the sale of a partnership interest is ordinary to the extent it relates to the value of the partnership’s inventory and Section 1245 property. (There are other items included in the ordinary income carve out of Section 751(a), but I don’t think those items are common with MLPs, so I’m ignoring them to keep this post as short as possible.) Section 1245 property is depreciable property, including Section 197 goodwill, used in a trade or business. The ordinary gain on Section 1245 property is limited to the amount of accumulated depreciation that has been claimed as a deduction by the partnership, and this gain is also called “depreciation recapture”. In order to do the computation of ordinary income, the partnership is treated as though it had itself sold all of its assets on the date you sold your units, then determines the amount of inventory gain and depreciation recapture that would result from a total sale, and then allocates to you your proportionate share of the ordinary income. For a citation, see reg. sec. 1.751-1(a)(2) for the way the gain gets calculated and the law itself for the rule. So the partnership is telling you that a portion of your gain represents the increased value of the partnership’s inventory and potential depreciation recapture under Section 1245.
Next, how is the sale of these types of assets treated for UBTI purposes?
IRC Section 512(b) tells you how to compute UBTI. Section 512(b)(5) says that in general you exclude gain from the sale of property from UBTI. But there is a specific exception to this rule in the law. Gain on the sale of inventory is not excluded from UBTI. So the inventory portion of the ordinary income is taxable for UBTI, straight from the law. Depending on the MLP, the inventory gain might be significant or not.
There is no similar exception for Section 1245 gain depreciation recapture in the law. But if you look at the instructions to Form 990-T (the UBTI tax return) at page 10, you will see that the IRS says that Section 1245 depreciation recapture is not excepted from UBTI (which is government speak for “It’s taxable”). The IRS’s reasoning for this conclusion is not in the instructions. In other documents (1 cited below), the IRS cites some Congressional Committee reports from when the UBTI rules were adopted to support the idea that the exclusion from UBTI for asset sales was only intended to apply to investment-type assets and not assets used in a business. So from this, the IRS concludes that Section 1245 ordinary gain is taxable for UBTI purposes because it arose in a business context.
So the IRS’ position is that both of these components of ordinary income are subject to UBTI.
Third, does the fact that the assets are used by a partnership, and not directly by your IRA, make a difference?
The answer is found in the Code – see Section 512(c) specifically states that an exempt organization that has an investment in a partnership must compute its UBTI by including its ratable share of the partnership’s income. I will also give you another cite in my next post, but it isn’t really needed – the law is straightforward enough on its own.
This post has gotten too long, so I’ll continue in a separate post.
Second post –A side trip - Even if you were somehow able to argue that the ordinary income was not UBTI, that wouldn’t solve your problem. IRC Section 514 imposes tax on another category of UBTI. That category is anything that escaped taxation under the general rule of Section 512, but only to the extent that the property that was sold was financed with debt. The simplest example of this would be that interest and dividends are not taxable to your IRA. But if you were to use margin in your IRA account (I don’t know any broker that allows this because of the tax rule, but let’s assume you did), your interest and dividend income would become subject to tax as UBTI to the extent of your margin. Since most MLPs use a lot of debt, it is likely that the debt-financed property rules of Section 514 would catch you even if the general rules didn't. I’ll give you a cite for this in a moment. But the debt-financing rules are really weird and specific; I only point them out because they are always lurking in the background.
The cite I can give you for this is a training manual that the IRS published in 1999 for its own employees. I got my copy on Lexis, which requires a paid subscription. The manual is many pages long, even the part on UBTI, so I can’t copy it. But maybe you can find it on Google. The title is IRS Exempt Organizations CPE Text for FY 2000: Chapter L, UBIT; Special Rules for Partnerships, and it was released on August 31, 1999.
That Manual actually addresses publicly-traded partnerships in the context of UBTI, although not in any detail. In 1999, there probably were no more than 15 MLPs and they weren’t as big as they are today. But the Manual concludes that MLPs are treated exactly the same as any other partnership in the UBTI context. At that time, people were arguing that MLPs were really investments and not active businesses for the IRA or exempt organization. The IRS rejected this argument. The rest of the Manual uses non-publicly-traded partnerships for its examples. It says several times that the general partnership rules apply to the UBTI issue. It goes into detail about sales of partnership interests and the debt-financed property rules. It concludes that under the partnership tax law, a partner is treated as owning his proportionate share of partnership assets and liabilities and concludes that the partnership liabilities can create debt-financed gains subject to UBTI.
The Manual does not address the more general issue of ordinary income under Section 751(a).
One last post to go.
Yes, this is unfortunately correct. I am not sure what is the true economic tax impact when making this calculation but definitely good cause for not owning this stock in an IRA. If you want to own in your IRA, you should be holding KMR, which is identical to KMP, but you are not required to compute UBTI since not a MLP.
I don't have a lot to offer, but in the comment section of that article someone says Howard Hinds agrees. (Hinds is considered to be fairly knowledgeable about MLP's.) I did check and he agrees with Welch. I can't remember the URL, but if you Google "Howard Hinds" you will find a link that gets you to his blog. In the "Search" link I typed in UBTI and found the information. I am also checking with my tax person and the tax advisor to my brokerage firm. I don't have much, but it is always nice to know.