Midstream companies have engaged in heavy buybacks and increased distributions this year due to increasing free cash flow. For advisors and investors looking to capitalize on the steady growth by the industry, understanding the tax implications is important when it comes to MLPs.
By investing in MLPs directly within a tax-exempt account, a client is opening themselves up to Unrelated Business Taxable Income (UBTI), a mechanism that was put in place to ensure that tax-exempt entities do not partake in business outside of their primary means of revenue, or that it is severely limited if they do. It is important to note that this does not apply to MLP ETFs or ETNs within a tax-exempt account.
UBTI is income that can be taxed from a tax-exempt entity and is particularly of importance in relation to retirement accounts and employee benefit plans; UBTI triggers Unrelated Businesses Income Tax (UBIT) for all manner of IRAs and benefit plans for employees.
The IRS defines UBTI as follows: “For most organizations, unrelated business income is income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purposes that is the basis of the organization’s exemption.” UBIT kicks in after $1,000 or more of gross income from a business that isn’t related to the tax-exempt one.
Because of the structure of MLPs as pass-through entities, from a tax perspective, an owner of an MLP is treated as if they were earning the income being created by the MLP directly. MLPs are publicly traded partnerships, and because they are not directly related to the primary business means of a retirement account, they incur UBTI.
While there isn’t anything that prevents an investor from holding MLP securities within their tax-exempt accounts — in this instance, their retirement accounts — they would be responsible for the UBIT on those securities. If not understood, it could be an unpleasant surprise for a client come tax season; advisors should also note that distributions and net income are different from taxable income.
ETFs provide a way for investors and advisors to gain access to MLPs, and midstream investing in this case, without incurring any tax obligations for their retirement accounts. An ETF is structured as a C-Corp and therefore is not considered a partnership when it invests.
Stacey Morris, CFA for Alerian, recently wrote an article explaining the interplay of UBTI, MLPs, and ETFs. In it, Morris explains that ETFs within a retirement account can be a bit of redundancy, and when calculating annual contribution limits into tax-exempt accounts, it is perhaps not the best approach; instead, she recommends the use of an MLP exchange-traded note for retirement accounts.
A number of midstream ETFs and ETNs track Alerian indexes and provide exposure to the positive themes in midstream.
See also: Buybacks Increased for Energy Infrastructure Companies
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