If the Trump administration's tax-reform plan gains traction, investors in master limited partnerships could be among the beneficiaries, which means financial advisers might want to start sharpening their pencils for some number crunching.
President Donald J. Trump's pitch to cap the taxes on so-called pass-through entities at 15% would increase the appeal of both direct MLP investments and mutual funds and ETF that invest in MLPs.
"I don't know if it was the intent [of Mr. Trump] to benefit MLPs, but working off that one line in a one-page proposal, it certainly looks like they would benefit," said Craig Richards, director of tax services at Fiduciary Trust Company International, the $78 billion private client division of Franklin Templeton.
"That kind of tax cap could suddenly make MLPs very attractive," he said.
MLPs, which are basically fee-collecting pipelines for oil and gas, can be a popular form of income investment. But as pass-through entities, the income is passed directly to the investor, where it is taxed at the individual's tax rate, which could be as high as 39.6%.
Capping that income at 15% would be a boon for the $600 billion MLP space, according to Phil Blancato, president and chief executive of Ladenburg Thalmann Asset Management, which has $2.2 billion under management.
"Right now the MLP sector is at least $300 billion underfunded, in terms of investment needed to build new pipelines," he said. "And since the vast majority of MLP investors are individuals, the tax cut could have a massive impact on the space, because investors would want to take advantage of it."
Independent tax and accounting specialist Robert Willens described MLPs as among the biggest investment beneficiaries of the proposed cap on pass-through entities.
"Unless [lawmakers] somehow decided that MLPs and their owners would be ineligible, there's no doubt that MLPs would fit the description of benefiting from the tax proposal," he said. "And it would be illogical to carve out an exception for MLPs because they are conducting business and they meet the requirement of pass-through status."
Even though most of the tax advantages of investing in MLPs is via direct investment, investors in MLPs through registered wrappers like mutual fund and ETFs also could benefit from the proposed tax cap.
"The primary tax benefit of owning MLPs and MLP funds is the ability to defer taxes on the annual distributions and potentially pay taxes at a lower rate upon disposition of the assets," said Jeremy Held, director of research at ALPS Advisors.
"MLPs already enjoy a significant tax preference under the current tax code," he said. "But it's important for investors to know the tax consequences of owning MLPs directly or in a fund."
In 2010, ALPS launched the industry's first MLP exchange-traded fund, the $10.5 billion Alerian MLP (AMLP).
While investors and financial advisers are sometimes deterred from investing directly in MLPs because of the more complicated tax-filing requirements, much of that complexity is avoided by investing through funds, Mr. Held said.
"Once you wrap an MLP into a pooled vehicle like a mutual fund, the tax structure changes because the fund is taxed as a corporation, and the type of distributions are determined by the underlying investments," he said.
The trademark of MLP investing is the steady income stream, which typically hovers between 4% and 6% annually. And most of that income is distributed in the form of a return of capital, which effectively lowers the investor's original cost basis.
That creates an appealing opportunity to postpone tax payments, according to Mr. Held.
"You have the ability to delay when you pay taxes and to pay at a more favorable rate," he said. "You're still paying the tax, but you're paying tax on something several years from now."
The MLP mutual fund and ETF space is still relatively small and the average investment performance has not been strong as of late, according to Morningstar data.
The category, known as energy limited partnerships, includes $29 billion in total mutual fund assets, and $20 billion in total ETF assets, half of which is represented by the Alerian ETF.
In terms of performance this year through May 8, the category had an average decline of 1.3%, compared to a 7.9% gain in the S&P 500 Index.
The category's 12-month return was 17%, slightly lagging the S&P's 17.6% gain.
And the category's three-year annualized return was a decline of 6.9%, compared to a 10.8% gain for the S&P.
If the tax changes go through, making MLPs more attractive to investors, it is likely that valuations will start to rise, which could increase total return while slightly reducing the annual income distributions to investors.
"If the MLP market goes into a 10% rally, an MLP fund would probably be up about 6%," said Jay Jacobs, director of research at Global X Funds, a $4.8 billion asset management firm with three MLP funds.
"Anything that makes individual MLPs more tax efficient would likely drive up valuations," he said. "So, the big takeaway is, more tax advantages will be a tailwind for price appreciation in the MLP space."