By Mark P. Cussen, CFP®, CMFC, AFC | January 05, 2016

Traditional and Roth IRAs are considered to be either tax-deferred or tax-free havens where an investor’s money can grow without needing to be reported on the 1040 each year. Dividends, interest and capital gains can accumulate in these accounts without one penny being taxed until withdrawal, if it is taxed at all. However, some taxpayers who had invested in a master limited partnership (MLP) received a very unpleasant surprise in the mail when they were notified that they owed a substantial amount in taxes on this investment, even though it was purchased inside their retirement plans and accounts. Unfortunately, the tax advantages provided by IRAs have a few additional little-known limits on top of the standard contribution and distribution rules.
Unrelated Business Income

While virtually all forms of investment income are exempt from current taxation in an IRA or qualified plan, “virtually” does not exclude a type of income the IRS calls unrelated business income (UBI). This type of income is generated when a tax-exempt organization generates income that is incidental to its real purpose. For example, if an educational institution runs a cafeteria for students that makes a profit, the institution will probably be required to report that income on its tax return even though it is a qualified 501(c)3 organization. (For more, see: Pros and Cons of Master Limited Partnerships.)

The investors who were notified of their unexpected tax liability were investors in a MLP offered by Kinder Morgan Inc. (KMI), a southern pipeline company in the oil industry. MLPs are popular with sophisticated investors because they allow for direct ownership of businesses without the double taxation that comes with corporations. These pass-through entities confer taxation for partnership income onto their unit holders, but the total amount of tax paid is less overall than it would be if the investors held shares of stock.

However, Kinder Morgan made the move to convert to a C corporation in 2014, which meant that all units of their existing MLP would have to be liquidated. This meant that all of the deferred gains and other passive investment income that was generated by these units would now become declarable as taxable income, even though these investors held the units inside their retirement accounts. In this case, the income generated by the sale was classified as unrelated business income by the Internal Revenue Service (IRS). A portion of the exchange of MLP units for shares will be reported as a capital gain or loss with the remainder being classified as ordinary income. In most cases, the IRA custodian will file a Form 990-T on behalf of its customers when this form of income is generated. (For more, see: MLPs: Time to Invest or Has Their Time Passed?)

However, to add insult to injury, the custodians for many of the IRA investors were also taken by surprise as a result of this bill, and firms such as Pershing were not able to file this form in a timely manner because the K-1 partnership income forms generated by Kinder Morgan did not have enough information on them to make the necessary calculations. The IRS then levied interest and penalties on all balances owed by IRA unit holders that substantially increased the amount that they owed. The custodians are now negotiating with the IRS to eliminate this additional amount, but the initial amount will still be due.
The Bottom Line

Although most types of income can be deferred inside a traditional or Roth IRA, their tax firewall does have some chinks. Many tax and investment experts caution IRA investors against buying MLPs that are traded publicly inside these accounts because of issues like the one described above. If you own shares or units of this type of investment in an IRA, consult your tax or financial advisor to find out whether you may face this type of liability at some point. (For more, see: Should I Buy an MLP for My Retirement Account?)

Read more: MLP Investors Hit with Surprise Tax Bill on IRA Income | Investopedia