What to watch for when investing in master limited partnerships

In an environment where yields are low and the stock market is lackluster, MLPs offer much desired returns and some legitimate diversification.

As Wall Street continues to package master limited partnerships inside retail-oriented products, financial advisers should pay close attention to the tax consequences of their choices.

Thanks to the Tax Reform Act of 1986, which was designed to boost investment in mostly energy-related infrastructure projects, traditional MLPs provide attractive tax advantages. That is because, as partnerships, they pay no state or federal income tax themselves.

Instead, distributions are taxed only at the marginal rate of their partners.

Once MLPs are wrapped in a mutual fund or an ETF, however, their distributions are taxed at the fund's corporate rate, and what is left is paid to shareholders as a distribution — which then is taxed as dividend income, thereby effectively nullifying the main reason for investing in an MLP in the first place.

But though direct ownership “is the best and most tax-efficient way to invest in MLPs,” according to Paul Justice, an analyst at Morningstar Inc., some advisers and their clients think that the benefits of investing in retail-oriented vehicles that incorporate MLPs outweigh the loss of the tax advantage.

“Direct MLP ownership can be quite cumbersome because investors might be required to file state taxes in every state in which an MLP operates,” said Jeremy Held, director of research at ALPS Advisors Inc., which manages $4.5 billion, including the $1.7 billion ALPS Alerian MLP ETF (AMLP).

Also, in cases of significant MLP ownership inside a qualified retirement account, the unique nature of the MLP income could trigger an automatic conversion to taxable-account status.

“That's normally not a problem, unless you're a really big investor, but it has the potential to become a major taxable event,” Mr. Justice said.

For those looking for ease of access and diversification, the financial services industry is at the ready.

Yorkville ETF Advisors LLC represents the latest entry into the packaged-MLP space with the Yorkville High Income MLP ETF, according to a prospectus filed in December with the Securities and Exchange Commission.

Like the only other MLP exchange-traded fund on the market — the ALPS Alerian MLP ETF — the Yorkville product will track a standard MLP benchmark.

The ETFs, along with the dozen closed-end funds and half dozen open-end mutual funds in the space, are structured to share some of the tax advantages of direct ownership.

Similar to the tax treatment of returns in a partnership, most of the distributions from registered funds are tax-deferred and considered a return of capital for tax purposes. With each distribution, of course, that return of capital effectively lowers the investor's cost basis.

For example, if a fund or MLP is purchased at $15 a share and then distributes $1 a year for 15 years, the cost basis at that time becomes zero. Additional distributions could even produce a negative cost basis.

This creates the kind of looming tax burden that has encouraged investors to hold their MLP positions until death, at which point the cost basis is stepped up to the current price for whomever inherits the investment.

That kind of lifetime time frame for an MLP investment should be enough to deter younger investors, but it could appeal to older income-seeking investors who are in or near retirement.

Then there are MLP exchange-traded notes, which look and act like ETFs but are more like bonds because they distribute interest, which is considered ordinary income and is taxed annually. Because of that tax treatment, ETNs are better-suited for qualified accounts.

Although the entire ETN market adds up to just $20 billion, compared with the $1 trillion in ETFs, there are already eight ETNs linked to MLPs.

The largest product in the space, the $3.2 billion JPMorgan Alerian MLP Index ETN (AMJ), tracks an index similar to the ALPS Alerian MLP ETF.

DOUBLE TAX

The difference between the 13% gain last year by the JPMorgan ETN and the 10% gain by the ALPS ETF essentially reflects the double tax on the ETF.

ETNs, as debt instruments, don't actually invest in the underlying MLP index but instead use investor money to replicate the performance of the index.

Of course, as with any debt instrument, ETNs introduce risks associated with the creditworthiness of the issuer.

Ultimately, it is a matter of picking the least objectionable vehicle, because with MLPs, there are snags everywhere you look.

However, in an environment where bond yields are low and the stock market is lackluster, MLPs offer much desired returns and some legitimate diversification.

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected]