Master limited partnerships offer an investment vehicle that can be an excellent way to generate income. This is because they typically distribute a significant portion of their cash flow to investors. However, master limited partnerships can also be confusing at tax time because they follow different tax rules than corporations.
There are also limits on the business activities that the partnership can engage in to avoid tax consequences being imposed on its investors. In certain situations, this can result in taxes being imposed on the company's investors even if the investment is held in a tax-advantaged vehicle like an IRA.
To overcome this problem, some master limited partnerships have chosen to structure themselves as publicly traded LLCs instead of true MLPs. Others have set up a publicly traded LLC as a limited partner in the MLP itself. One example of this second structure is Kinder Morgan Management, LLC (NYSE: KMR).
How Kinder Morgan Management works
Kinder Morgan Management, LLC is a limited partner in Kinder Morgan Energy Partners (NYSE: KMP). As such, it receives distributions from the pipeline partnership just like any other investor in the partnership would. Unlike most investors, though, Kinder Morgan Management only has one asset, and this asset is partnership units in Kinder Morgan Energy Partners.
What the company basically does is take the distributions that it receives from the partnership, uses them to buy units of Kinder Morgan Energy Partners, and then pays out a dividend in units of Kinder Morgan Management so that the ratio of LLC units to partnership units in the company's portfolio remains constant. As a result, Kinder Morgan Management and Kinder Morgan Energy Partners have about the same distribution.
This is evident in the two companies' annual returns. Kinder Morgan Management has produced an annualized return of 13.9% since its IPO in 2001, while Kinder Morgan Energy Partners has produced an annualized return of 13.8% over the same period.
Advantages over Kinder Morgan Partners
Because Kinder Morgan Management is a limited liability company and not a master limited partnership, it is not subject to the laws surrounding unrelated business taxable income (UBTI). The official definition of UBTI is income generated by a tax exempt entity through activities that are not exempt from taxation. I realize that this sounds a bit confusing, so here's how it relates to MLPs.
Basically, master limited partnerships are only allowed to produce income from certain activities in order to retain their ability to pass their income through to unitholders in a tax-advantaged manner. These industries are real estate, commodities, and activities in the energy industry such as the extraction and transportation of natural resources. If any part of the partnership's income comes from some other activity, then this income is considered unrelated business taxable income and is subject to taxes. The liability for these taxes passes through the partnership structure and is imposed on the partnership's unitholders.
The big problem comes in when the master limited partnership passes this unrelated business taxable income through to an investor that is holding partnership units in an IRA. This has to do with the way that the income is taxed. Normally, all income generated in an IRA is tax deferred until the investor takes the money out at retirement. That is not the case here, though. If any of this UBTI is passed through into an IRA, the tax on that income must be paid by the owner of the IRA in the year that it is received.
An LLC can participate in any business that it wants, and this means that it is not subject to the laws surrounding the UBTI. As a result, an investor can freely hold units of a publicly traded LLC like Kinder Morgan Management in an IRA without any risk of adverse tax consequences.
Foolish takeaway
In general, your IRA may not be the best place to put the units of a master limited partnership. However, companies like Kinder Morgan Management offer a great way to get all the benefits of an MLP in your retirement account without having to take on the negative aspects of investing in this way.
