MLPs: Tax Noodling For Next Year

April 19, 2011

It’s too late to fix your 2010 taxes, but the new raft of MLP ETFs might help for next year.

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.

 

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