Investors are always looking for ways to manage their tax situation, whether that’s through tax-deferred accounts like a 401(k), or through tax-efficient vehicles like a traditional equity ETF. Any investor who looks hard enough for tax-advantaged investments will inevitably stumble across a unique type of vehicle known as the master limited partnership (MLP).
MLPs were designed as a kind of investment pooling vehicle with a specific goal in mind: to pass the income earned in some form of partnership directly to investors. By law, they can only be used for businesses where 90% or more of the revenue is being generated from certain qualifying activities, such as managing natural gas pipelines or storing crude oil—industries that generate steady income streams, but that also require large investments in infrastructure that need to be depreciated over long periods of time. In short, an MLP combines the pass-through tax treatment of a traditional partnership with the public tradability of a stock, much like a real estate investment trust does for the ownership of property.
MLPs therefore satisfy a wide range of investors, and can offer attractive yields (the indicative yield on the Alerian MLP index is 5.82% as of 1/29/2013) that are paid quarterly. Historically, these yields have made MLPs a favorite with investors living on fixed incomes, but the current zero-interest-rate environment in the U.S. has pushed pretty much any yield-seeking investor toward the asset class.
Like any individual investment, however, buying shares in one MLP exposes you to single-company risk. Further, MLP owners are required to pay income taxes in every state in which the MLP does business; will receive a K-1; and are subject to the rules surrounding unrelated business taxable income (UBTI). In a bid to diversify these risks, closed-end fund issuers were the first to create portfolios of MLPs structured as C-corporations. In the past few years, the advent of exchange-traded products (both exchange-traded funds and exchange-traded notes) has further enabled investors to get easy, diversified access to groups of MLPs. However, the tax benefits of MLPs, which are outlined in this paper, cannot be completely replicated in any of these structures. Each has pros and cons that necessitate careful consideration of personal tax issues, diversification requirements and other factors that complicate traditional index fund analysis. Some of the benefits of owning individual MLPs—particularly tax-deferred income—are significantly modified in all of these structures.
In choosing a pooled investment structure, investors are trading in the tax efficiency of holding individual MLPs for the diversification and liquidity benefits of the ETF and ETN structures. They are also swapping the complex taxation and difficult fit of individual MLPs in tax-deferred accounts for tax simplicity and universal eligibility. It’s an imperfect trade-off, and investors willing to brave the vagaries of the tax code and single-firm risk may be better off holding individual MLPs rather than a pooled vehicle.
This paper reviews the investment case for MLPs and discusses how to compare, contrast and evaluate various exchange-traded approaches to accessing the MLP market. We pay particular attention to the impact of taxes and distributions on an investor’s returns, as these are both the most important and most misreported aspects of MLP analysis. In the course of our analysis, we assume investors are at the highest marginal tax brackets, using the post-“fiscal cliff” tax environment as of Jan. 1, 2013.
Ultimately, the type of structure you choose is based on your own individual tax situation and your expectations for the MLP moving forward.