7771 / Can a master limited partnership (MLP) become subject to the unrelated business income tax?

Although the tax benefits that can be realized through investment in MLPs have generated much interest among investors, it is, as always, important that advisors counsel investors about the pros and cons of MLP investing before allocation of MLP interests for their portfolios. As noted in Q 7768, one attractive feature of the MLP is that it is subject to only one level of taxation. Despite this, certain tax-preferred entities (such as 401(k)s and IRAs) and organizations (such as charities and churches) may actually run afoul of a different tax as a direct result of their investment in MLPs.

Like individual taxpayers, certain tax-preferred entities (such as 401(k)s and IRAs) and organizations (such as charities and churches) can become limited partners upon investment in a MLP. However, any income derived from the partnership will be subject to the unrelated business income tax (UBIT), as this income will be classified as unrelated business taxable income (UBTI) to such entity or organization.¹ UBTI is “gross income derived by any organization from any unrelated trade or business . . . regularly carried on by it.”² An “unrelated trade or business” is defined to include “any trade or business the conduct of which is not substantially related . . . to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption.”³

MLP income distributed to a tax-exempt entity or organization will very likely constitute UBTI. For example, income that is passed through to a 401(k) or IRA based on an investment in a MLP is not related to a retirement account’s tax-exempt purpose of encouraging taxpayers to save for retirement and, therefore, will become subject to the UBIT. Additionally, if a tax-exempt organization invests directly in a MLP, any partnership income will become subject the applicable corporate tax rates, because that income is not related to the organization’s exempt purpose.⁴