Certain types of investments report income to investors on a K-1 form instead of the familiar Form 1099. With investments held in an IRA, you don't have to worry about the tax consequences or the 1099 earnings – the IRA grows tax-deferred. But if you have K-1 earnings in an IRA, it's possible some tax forms may need to be filed and even some taxes paid.
You can use IRS Schedule K-1 to document any income generated via an IRA in situations where these profits originate as part of a business partnership.
Partner Income Tax Reporting
The K-1 form is used by partnership businesses to pass through business results to the partners. A partnership does not pay taxes. Instead, the partners pay taxes on the earnings and get to claim any deductions. Publicly traded partnerships, referred to as master limited partnerships, are bought like stocks but pass through income like a partnership. Your IRA would have K-1 income if you invested in Master Limited Partnership, or MLP, stocks with your IRA money.
Unrelated Business Income
Tax rules require tax-advantaged accounts like IRAs to pay income tax on what is called "unrelated business income." An IRA holds investments and partnership income may not be investment income, resulting in UBI from your partnership investments. The amount of unrelated business income from your IRA's partnership investments will be listed as such in Box 20 of the K-1 form. Only the amounts of unrelated business income are important concerning taxes and your IRA account.
Exploring IRA and UBIT Policies
If your IRA earns more than $1,000 in unrelated business income as reported on the K-1s you received, the IRA must pay unrelated business income tax – UBIT – on the amount above the $1,000 cutoff. Not all of the distributions you receive from MLP investments will be UBI, and many partnership investments will report little or no UBI on the K-1s they send out. If the K-1s you received total to less than $1,000 in UBI, there is nothing you need to do. With more than $1,000 in UBI you need to contact your IRA custodian.
Filing a Return
Your IRA and not you is responsible for paying any UBIT. The custodian of your IRA will complete and file a tax return in the name of your IRA account. The custodian will charge a fee for this service and any taxes due will come out of the IRA value. If you see that your UBI on the partnership investments in your IRA is greater than the $1,000 exemption, you should be prepared to pay additional taxes back to the IRS on your annual return.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.