Many investors are sitting at their kitchen tables, going over
the aftermath of their 2010 decisions. There were plenty of places
to get tripped up in the ETF landscape, and master limited
partnerships (MLPs) and the ETFs that track them caught some
investors off guard.
When Alerian launched the first honest-to-goodness ETF
consisting of MLPs last fall, I'll admit that I didn't instantly
grasp what it offered over existing funds targeting the same
pattern of returns. Sure it gets rid of the credit risk attached
with competitive offerings (which are ETNs), but does it offer
better after-tax returns?
The Alerian MLP ETF (NYSEArca:AMLP) is the first (and so far,
only) ETF to actually hold a basket of MLPs-partnership shares
predominantly in oil and gas pipeline companies that have a
reputation for consistent yields. But unlike most ETFs, the fund
had to register as a corporation, which makes it potentially
susceptible to double taxation:As each partnership pays out, AMLP
must file its own tax return and pay Uncle Sam before AMLP can pay
its ETF shareholders. Many investors have expressed concern over
this structure, but it turns out it may still be more tax efficient
than its ETN counterparts.
For a long time, investors have bought MLPs as a chance to get
large dividends in a tax-efficient structure. The limited
partnership passes through income directly to investors in the same
form in which it was received by the partnership, allowing income
to be taxed once on the individual investor's tax filing.
Furthermore, due to deductions from depreciation, it's typical for
only 30 percent of MLP distributions to be considered taxable in
any given year, with most of the other distributions being labeled
as nontaxable return of capital.
But the advantages of directly owning MLPs can be soured by the
complexity of actually filing taxes. MLPs issue K-1s, which have
long been a source of discontentment among investors. State taxes
have to be filed in each state the MLP earns income, and many IRA
or ERISA accounts are excluded from investing in MLPs due to
unrelated business taxable income, or UBTI.
Then along came the JPMorgan Alerian MLP ETN (NYSEArca:AMJ) in
April 2009. It offered investors exposure to the performance of a
basket of MLPs by promising the return on an Alerian index, minus
expenses. Since then, many more ETNs have been created to track
While the ETN structure gave investors access to the returns and
distributions of an underlying index of MLPs, it didn't match the
after-tax returns. Since an ETN is fundamentally just a bond, all
of the income from an ETN is taxed as ordinary income, and
investors don't have the ability to receive that 70 percent or more
of their distributions as return of capital. In addition, since an
ETN is an unsecured note, it loses this tax benefit while gaining
When the Alerian MLP ETF (
) launched in August 2010, the situation changed. Equity ETFs are
usually structured as a registered investment company (
), which passes through income directly to investors. To get this
pass-through treatment, RICs need to follow certain rules. Owning
nothing but MLPs doesn't follow those rules, so AMLP doesn't get
the pass-through treatment, plain and simple. Instead, AMLP is just
a regular old company. And like any company, the fund is subject to
taxation at the fund level. But it's important to understand how
this structure works with MLPs before jumping to conclusions that
the tax is higher.
All distributions from MLPs inside the fund are taxed based on
the nature of the distribution, meaning that income is taxed as
income to the fund; and that return of capital is nontaxable. With,
on average, 70-100 percent of MLP distributions being return of
capital, most of these distributions are not taxed at all at the
AMLP, after paying for any taxes and expenses, distributes the
remainder to investors. If the fund is internally profitable as a
corporation, then the portion of the distribution that represents
profits will be passed out as a normal dividend to investors.
Return of capital from the MLPs will be labeled as return of
capital to the investor, and the capital is not subject to the
Unfortunately, it can get even more confusing for investors.
Partnerships pass through not just profits, but accounting items
such as depreciation, and there can be mismatches in the accounting
laws between the MLP's distributions to the fund, and the fund's
distributions to investors. This creates unusual-although
technically accurate-situations like we see now, where 100 percent
of AMLP's distributions to date are being treated as return of
capital since inception. Because AMLP is sitting on passed-through
depreciation, it doesn't actually show any internal corporate
profits, so every dime that's gone out to investors has been
tax-free return on capital. Obviously, this is unlikely to continue
So, when measuring the tax efficiency of MLP investment
vehicles, what can investors take away?
- Individual MLPs still are the most tax efficient, but they
have real complications that many investors may not want to deal
with. Funds also offer diversification of MLP holdings.
- ETFs offer better tax efficiency than ETNs for most investors
due to the ability to retain return-of-capital tax treatment for
some of the distributions from the underlying MLPs. The pretax
returns of the fund will likely show higher tracking error to the
index vs. the ETNs, but the after-tax returns could be
- ETNs may still offer better performance for IRA or
tax-deferred accounts (although since MLPs are most often used
for tax reasons, holding MLPs at all may be a rare occurrence).
With ETFs being taxed mostly at the fund level, investors are
unable to avoid these taxes. ETNs have all their taxes taken at
the investor level and can be avoided in certain accounts.
While MLP ETFs may seem complicated, they give investors a great
alternative to the previous structures in existence.
Don't forget to check IndexUniverse.com's ETF Data
2011 Index Publications LLC
. All Rights Reserved.