There is no statute or other article of law–be it the federal tax code or rules and regulations covering pensions–that prevents IRAs, Roth IRAs or other qualified retirement accounts from holding master limited partnerships (MLP).

There are practical considerations, however, that illustrate the very basic point that a tax-deferred or tax-advantaged investment is best held in a taxable account.

One key reason to buy MLPs is for the tax advantages–the tax-deferred distribution and the ability to shelter taxable income passed through from the MLP with depreciation and other deductions. In a retirement account, however, the income is already tax-deferred, so the tax benefits of an MLP are essentially forfeited.

More importantly, contrary as it may seem, holding MLPs in a retirement account can result in the account owing tax.

Sections 511 through 514 of the Internal Revenue Code (IRC) focus on a concept known as “unrelated business income tax” (UBIT). Under the IRC’s UBIT rules, tax-exempt organizations and retirement accounts must pay tax on their “unrelated business taxable income” (UBTI)–income from a business that is not related to their exempt purpose.

If your IRA invests in an MLP, it becomes a limited partner in that MLP, just as you would if you invested directly.  Because of the pass-through nature of an MLP, the partners are treated by the IRC as if they’re directly earning the MLP’s income.

As a partner in the MLP, the IRA, for example, is deemed to “earn” its share of the MLP’s business income.  The MLP’s business isn’t related to the retirement account’s tax-exempt purpose, so the IRA’s share of the MLP’s income is treated as UBTI and is taxed accordingly.

The tax is owed on the retirement account’s share of the MLP’s taxable business income, minus its share of depreciation and other deductions related to the business, as reported on the K-1 form (not on the quarterly distributions).

The tax rate is the top corporate rate, which is 35 percent. There is a deduction that covers the first USD1,000 of UBTI from all sources. Above that the retirement account will owe tax.

An extensive comment on an article posted at the popular investing website Seeking Alpha suggest that UBTI can come from the annual K-1 as well as from the disposition of the MLP units, a transaction through which the Internal Revenue Service (IRS) could seek to “recapture” partnership income by removing the “shield” provided by the past depreciation deductions and depletions taken by the MLP.

Section 512 of the IRC provides that the term “unrelated business taxable income” means the gross income derived from any unrelated trade or business regularly conducted by the exempt organization, less the deductions directly connected with carrying on the trade or business.

The UBTI issue is unlikely to cause a tax problem in a given year for investors with modest MLP holdings. At the same time, however, there is the issue of “wasting” the tax benefits of these vehicles inside an account that’s already advantaged by the IRC.

I would also describe the issue raised in the Seeking Alpha colloquy referenced above as “unsettled.” My extensive reading on the subject suggested one possible outcome, but in an age when federal revenues and means of enhancing same are such a hot topic I–being neither an accountant nor a tax attorney–am hesitant to dispense any authoritative conclusions.

I would simply leave it at this: It’s best to avoid these issues for your IRA by not making investments that can generate UBTI. Putting MLPs in your retirement account invites the possibility of additional expenses, which eat into your total return.

The IRC makes clear that any tax arising due to UBTI is owed by the IRA or other retirement account itself, as it is the partner in the MLP. But it’s the responsibility of the custodian of the account to file a tax return–Form 990-T, the return for tax-exempt organizations–and pay any tax owed out of the account’s funds. For this your custodian will charge you a not-insignificant fee.

If you’re going to generate a tax, do it on your personal return. You have to file it anyway.

Alternatives

Linn Co LLC’s (NSDQ: LNCO) entire asset base consists of Linn Energy LLC (NSDQ: LINE) units. MLP Profits Portfolio Growth Holding Linn Energy is one of this month’s two Best Buys.

Linn Co has no assets or operations other than those related to its interest in Linn Energy, meaning its financial condition and results of operations depend entirely upon the performance of Linn Energy.

Linn Energy is taxed as a master limited partnership, which means it’s not entirely suitable for a retirement account such as an IRA or a Roth IRA. Linn Co, on the other hand, is taxed as a corporation. It is taxed at the entity level and pays dividends to shareholders. It is suitable for holding in an IRA.

Linn Co LLC is a buy under USD40. See this month’s Best Buys feature for more on the underlying assets and Linn Energy’s operating performance during the fourth quarter and for 2012.

Kinder Morgan Management LLC (NYSE: KMR) is a fine alternative to Conservative Holding Kinder Morgan Energy Partners LP (NYSE: KMP).

Kinder Morgan Management (KMR) owns a limited partner interest in and manages Kinder Morgan Energy Partners (KMP), the energy transportation and storage MLP with 46,000 miles of pipelines and 180 terminals in North America.

KMR’s performance is a function of the operating success of KMP. During 2012 KMP declared total cash distributions of USD4.98 per unit, an 8 percent increase from 2011.

KMR, like KMP, declared the equivalent of USD4.98 per unit for 2012. Since its formation in May 2001 KMR has delivered an average annual return to shareholders of 15 percent.

The dividend to KMR shareholders is paid in the form of additional KMR shares. It’s calculated by dividing the cash distribution to KMP unitholders by KMR’s average closing price for the 10 trading days prior to KMR’s ex-dividend date.

For the fourth quarter of 2012, for example, shareholders of KMR received a USD1.29 dividend, or USD5.16 on an annualized basis, on Feb. 14. Kinder Morgan Management is a buy under USD85.

Kayne Anderson Energy Total Return Fund (NYSE: KYE), which is yielding 6.8 percent as of this writing, is a closed-end fund that invests primarily in energy-related equities, including MLPs.

The key advantage of closed-end funds and exchange-traded funds over individual MLPs is that investors don’t need to deal with multiple K-1 forms during tax season. Instead, the fund will send you a 1099 each year that breaks the distribution down into income and realized capital gains/losses on transactions.

MLP-focused funds also offer the benefit of instant diversification, which helps to cushion the blow if one portfolio holding implodes. There’s also the value of professional management, though that’s difficult to assess with funds that have a short operating history.

But we generally prefer building a portfolio of individual MLPs to investing in actively managed closed-end funds, which feature higher fees, and passively managed exchange-traded funds (ETF), which lack the focus on quality that comes with selecting individual stocks.

If you’re going looking for simplification–or want MLP exposure for your IRA–Kayne Anderson Energy Total Return Fund is a solid alternative.

As of Dec. 31, 2012, the fund’s asset allocation included 48 percent MLPs and MLP affiliates; 16 percent marine transportation and “other” companies; 13 percent debt securities; 12 percent midstream and utility companies; and 10 percent US and Canadian income trusts.

Its top 10 holdings included Kinder Morgan Management, Enbridge Energy Management LLC (NYSE: EEQ), Plains All American Pipeline LP (NYSE: PAA), Golar LNG Partners LP (NSDQ: GMLP), Teekay Offshore Partners LP (NYSE: TOO), Capital Product Partners LP (NSDQ: CPLP), The Williams Companies Inc (NYSE: WMB), Kinder Morgan Inc (NYSE: KMI), Navios Maritime Partners LP (NYSE: NMM) and Regency Energy Partners LP (NYSE: RGP).