MLPs: Tax Noodling For Next Year

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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 similar indexes.

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 default risk.

When the Alerian MLP ETF ( AMLP ) launched in August 2010, the situation changed. Equity ETFs are usually structured as a registered investment company ( RIC ), 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 fund level.

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 dividend tax.

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 indefinitely.

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 substantially better.
  • 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 section.

Copyright ® 2011 Index Publications LLC . All Rights Reserved.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: AMJ , AMLP , RIC

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