The Taxman is coming for your IRA, Roth, or HSA – if you own MLPs

As I discussed in a prior article,  I was shocked to see that my broker was sending in a Form 990-T for what I thought was a minor holding in my HSA (health savings account). This is a discussion of my personal experience. I hope it serves as a warning to others, though I am certainly not a tax expert or someone from whom you should be taking advice. While this example uses Energy Transfer and its subsidiaries ET, USAC, SUN as the example, I believe the topic is relevant to all the other MLPs (master limited partnerships) out there. It just might resonate more with Energy Transfer (ET) holders.

The background

I purchased 1,000 shares of Energy Transfer (ET) in the first quarter of 2020 in my HSA. I held those shares until the second quarter of 2021. In that time, I collected $1,372.50 total over six distributions. The last three distributions were half of the prior ones since ET had cut its distribution. When I sold the shares, 2Q21, I had a loss of $925. Given the reasonably small amount of distributions, and the fact that I sold at a loss, I had no expectation of tax consequences at all.

 

For those not familiar, HSA’s are great in that they are triple-tax-free. The money you contribute is untaxed. The return you gain on those funds is untaxed. If you spend those funds on qualifying medical costs, the withdrawal of funds isn’t taxed. If you’re over 65, you can treat an HSA like an IRA and draw funds from it. In that case, you are taxed as if you had withdrawn the funds from an IRA. Therefore, for tax treatment they are very similar to IRAs.

 

I was very surprised in the Spring of 2022 when my broker sent me a correspondence explaining that they were going to file for an extension for my HSA since I may owe taxes. In the case of IRA, Roth-IRA, HSA accounts, you aren’t the one responsible for the tax, your account is. It is the brokerage’s responsibility to file the tax forms for the account.

 

In Summer of 2022 I received correspondence from the brokerage with a copy of the 990-T that was filed. I was advised that on a particular date I need to have funds available in the account for payment of the tax. In my case that was $37 to cover the tax. Not a big deal. The big deal was that prior to this in January 2022, I had committed a substantial amount of my IRA and Roth-IRA portfolios to Energy Transfer. If I owed money on such a small return, what was I going to owe on a much larger return? I now was starting to understand why the general advice is Don’t hold MLP’s in tax-exempt accounts (IRA, Roth-IRA, HSA, etc.). I decided I needed to know much more about this process and try to estimate what my risk was, i.e., what is my potential tax exposure in the IRA and Roth-IRA accounts.

 

The process

Not understanding how I could possibly owe tax on such a small amount of distributions and after taking a substantial loss on the shares, I decided to appeal. I went through my K-1, and I could find nothing that looked like I’d owe tax. After all the UBTI (line 20AH1) on my K1 was $362, -$6, $18 for ET, USAC, and SUN. If the total UBTI was only $374, and you have a $1000 deduction, how could I owe tax?

 

A development that I became aware of, is that recently some brokerage houses have moved from doing the taxes for IRA, etc., accounts themselves, to jobbing it out to an accounting firm. My appeal that they had to be wrong about this was met with a document explaining the process. Excerpted from the document:

 

·       The IRA threshold of $1000 is for total income and not just UBTI.

·       Below is the general calculation used to determine total positive Unrelated Business Taxable Income (UBTI) is as follows:

 

o   The Ordinary Gains (found on the K-1 Tax Form) and the Capital Gains/Losses, for all partnerships sold during the previous year are added together.

 

o   Below is the calculation for Capital Gain/Loss Included in UBTI.

 

§  The Original Cost Basis + Cumulative Adjustments to Basis = Adjusted Basis

§  Proceeds - Adjusted Basis = Net Gain/Loss

§   Net Gain/Loss - Ordinary Gain (reported on the K-1) = Total Capital Gain/Loss

§   Total Capital Gain/Loss * Partnership Debt Ratio (Provided by Partnership separately) = Capital Gain/Loss Included in UBTI

o   This amount is then added to the Box 20V amount, the Ordinary Gains, and Net Operating Loss amounts for each partnership held in the retirement account. Please note, negative UBTI, Ordinary Gains, or NOLs can only offset gains for the same CUSIP. Losses are not aggregated across the account to reduce the taxable income.

o   All customers will have a $1,000 IRS deduction, shown on Part I Line 8 and some clients will have a 199A deduction shown on Part I Line 9. Their final amount is entered on Part I Line 11 (Total UBTI) of Form 990-T.

o   The amount of tax owed, on Part III Line 9 of Form 990-T, is based on the total UBTI from Part I Line 11 and the appropriate tax rate for Trusts or the Schedule D rate (whichever is more advantageous), as well as their accrued penalties and interest. Related details can be located in the Form 990-T Instructions (available at www. IRS.gov).

 

The result

I then went through my K-1 and 990-T to understand where the numbers had come from. The 990-T stated that I had $1457 in total UBTI, less the $1000 deduction and $91 for Trusts, for a total of $366 in UBTI i.e. (1457 – (1000 + 91)) = 366. The tax on the $366 was $37.

 

To try to estimate my potential obligation on my IRA and Roth-IRA holdings, I needed to understand where the $1457 in UBTI had come from. I went through the supporting tax forms and my K-1 to find that the starting UBTI was $2508. This came from my K-1 line20AB Section 751 Gain (Loss). The line was $2436, $32, $40 from ET, USAC, SUN respectively. That total of $2508 was then reduced by my capital loss of -$925 on the shares’ sale. It was further reduced -$126 for partnership losses (non-passive loss minus non passive gain). This is where the $1457 came from. So, if I hadn’t sold the shares at a loss, I would have owed even more tax. I wouldn’t have had the $925 in loss to deduct.

 

With this understanding in hand, I went back to trying to estimate how much my accounts will owe in tax this year. I had distributions in the mid-five-figures and capital gains in the very low-six-figures. I concluded that there was really no way that I can predict what the tax cost will be for those accounts. Given that so much is based on a K-1, of which I have very little forward visibility, I can’t hazard a guess. For example, what will the partnership’s debt ratio be for 2022? I have no idea.  I can only surmise that if I owed money on a reasonably small HSA, I’m going to owe a lot more on these investments. The only cheer I can take is that they probably can’t tax me, or rather my accounts, more than I’ve collected. I bounced around looking at rates, and as best I can tell, the rate looks to be capped in the 30-40% range.

 

The conclusion

To the people who have advised Don’t hold MLP’s in tax-advantaged accounts, you are correct. What I’ve been missing all these years, is why?. I took the risk of owning a large MLP position in my IRA since I’d held smaller amounts (but much larger than the HSA), for longer periods of time, collected much more in distributions – and never had any tax issues. I don’t know if the move to job-out the preparation of these forms to an accounting firm has been a catalyst, but something seems to have changed. I have heard people say, my brokerage just looks at the UBTI line and if it’s less than $1000, they don’t do anything. That seems to have changed.

 

I’ve also heard people say, I’m going to hold this in my IRA until I die, and my kids can deal with it. Again, I’m no tax expert and I certainly am not giving advice. I have been told that a MLP held in an IRA doesn’t get the basis-reset at death that would happen if it was held in an investment account. As I understand it, heirs of an investment account get a step-up in basis on the day that you die. The IRA holding the MLP will continue to owe taxes until it’s sold. When sold, your heirs or their accounts, will have to pay all the taxes due. So, all the distributions that you’ve collected over the years, will in a sense become taxable. Those distributions will be subtracted from your cost basis to calculate your gain, which is then factored into the UBTI and taxed. You may not be leaving as much as you think to your heirs.

 

I did contact both of my brokerages and asked for any heuristics that they might have for people in this situation. Will my accounts owe 10%, or 30-40%? They both said, we have no idea. Given that there is so little information on this topic out there, I wrote this article mainly to try to help others in my situation understand the issues. I thought that perhaps a real-world example might help you to better see those issues. Hope it helps you.