Many clients have discovered, to their dismay, that holding master limited partnerships (MLP) inside an individual retirement account (IRA) or simplified employee pension individual retirement arrangement (SEP-IRA) can create serious tax liabilities for the supposedly tax-deferred account. Filing Form 990-T, Exempt Organization Business Income Tax Return, and paying tax is required when the MLP has unrelated business taxable income (UBTI) over $1,000 from operations or from the sale of units.
Now for the really bad news. The Forms 990-T prepared by the accountant hired by the broker may be wrong, and not usually in the client's favor.
MLP units held within an IRA are taxed in basically the same manner as MLP units held in a taxable account. The major difference is that only the UBTI, the ordinary income, and possibly a portion of any capital gains are taxable in the IRA. Since the UBTI amount is provided to the partner on Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., the other line items can be safely ignored.
For example, a prominent brokerage firm hired a major accounting firm to prepare two Forms 990-T for 2017 for its client. The client received notice that the forms were ready to be filed on Sept. 17, 2018, but ignored the notice assuming that the IRA income was all tax deferred. The extended due date was Oct. 15, 2018, but it is unclear whether an extension was requested. Penalties and interest had already accrued due to late filing. No supporting documentation, such as facsimile Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, or workpapers were provided by the preparer. But the client was advised to review the returns with a tax adviser. Substantial tax was owed and paid out of the IRA on Oct. 15, 2018.
After the client became aware of the taxes paid from the IRAs, which occurred after Oct. 15, 2018, the client contacted his broker requesting copies of the workpapers supporting the tax return. The preparer procrastinated and just sent another copy of the tax return.
Over the next few months information was obtained from the broker, but not from the accounting firm hired by the broker, about the details of the sale of the MLP units. Upon review and reconstruction of the data by a preparer hired by the IRA holder, significant errors were discovered in the tax return. Ordinary income was not allocated correctly between the two IRAs, capital gains were overstated, and prior year suspended losses were not deducted. The original preparer did not provide any information until the client's personal accountant prepared amended Forms 990-T and submitted them for filing by the fiduciary. The amended return resulted in the following changes:
Basis adjustments and ordinary income
Basis adjustments to the purchase price and the ordinary income portion of the overall gain on sale are provided in the notes to the Schedule K-1. Ordinary income reported from the sale of the MLP units is reported on Form 4797, Sales of Business Property, and this ordinary income should match the Schedule K-1 amount. The ordinary income is taxable in full. Any limitations related to Sec. 1245 or 1250 gain recognition have already been accounted for by the partnership.
UBTI suspended losses
Suspended UBTI losses are deductible on the return for the year of sale. Since the broker's accounting firm had only the current and one prior year Schedule K-1, and did not have any of the older years' Schedule K-1s, the suspended UBTI losses were completely overlooked for the years before the sale. A huge red flag is when the basis adjustments are large reductions, but the UBTI losses claimed are relatively small or exactly match the amount reported on the Schedule K-1 for the year of sale. Basis adjustments include cash distributions, but the adjustments also include the suspended UBTI losses. When the basis is reduced for these adjustments, but the suspended UBTI losses are not claimed, taxable income is overstated.
Obviously, if the client has the prior year Schedule K-1s, the UBTI loss carryover can be easily calculated. When they are unavailable, the cash distributions schedule is usually easy to download from the MLP website on a per share basis, and distributions can be reconstructed for the client. Subtracting the cash distributions from the basis adjustments should give a reasonably close estimate of the accumulated UBTI losses. In fact, this probably understates the UBTI losses because other non-UBTI investment income has reduced the reported basis adjustments.
Capital gains upon sale may be partially taxable due to allocation of income from debt-financed property under Sec. 514. The determination of the taxable amount is tricky. The debt ratio percentage is the average acquisition indebtedness (numerator) over the average basis of the debt-financed property (denominator). This percentage of the capital gain is taxable. The remainder is not UBTI and therefore not taxable. The debt ratio percentage is not readily available from the Schedule K-1 or the instructions/attachments. The preparer needs to contact the partnership directly to obtain the percentage.
Filing the amended return
The statute of limitation for Forms 990-T for the year ended Dec. 31, 2016, is about to be closed and those forms will not be able to be amended. In addition, the amount of work required to review the Forms 990-T is significant, particularly when the preparer for the broker refuses to provide documentation underlying the tax return. The engagement cost should be weighed in comparison with the tax paid by the IRA holder before commencing the work. Once the UBTI losses, the basis of the units sold, and the taxable portion of the capital gain were corrected, the client in the example recovered over $23,000 of IRA funds.
Remember that the fiduciary is responsible for reviewing and signing the amended return, not the IRA owner. This can create a significant time delay in the filing of the amended return. Typically, the fiduciary and the original preparer will require documentation of any proposed corrections. Since the fiduciary is not a tax professional, he or she may even ignore an amended return completed by the client's accountant and have the original preparer complete it with the corrected information. If the tax was significant on the original return, it is worth a second look as to the reasonableness of the amounts reported.
Janet C. Hagy, CPA, is a shareholder of Hagy & Associates PC in Austin, Texas, and is also a former member of the AICPA Tax Practice and Procedures Committee. To comment on this article or suggest an idea for another article, contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.