The net effect: Most of the taxes on income are deferred until investors sell their shares, at which point they pay taxes on a proportionally larger capital gain. With this opportunity comes complexity: Direct MLP owners must contend with K-1 filings and may need to file tax returns in more than one state.
MLPs in Exchange-Traded Products
The rules of the game change if MLPs are held in in an exchange-traded product, where legal structures come into play.
Exchange-traded notes and C-Corporations dominate by assets, with roughly $10 billion in each structure. Traditional ETFs are relatively new to the MLP space, with about $1 billion in assets total. Two themes are clear: Each structure comes with trade-offs; and no structure matches the exposure of directly holding a basket of MLPs (Figure 2).
Exchange-Traded Note MLPs
ETNs deliver a clear advantage: pure exposure to MLPs. They can accurately match the performance of a basket of MLPs—something C-Corps and ETFs can't do. The downside: ETNs completely forgo any deferred tax advantage on the income they produce. ETN cash flows are taxed as ordinary income.
There's irony in ETNs "pure exposure" advantage: They don't actually hold any MLPs. As debt instruments, ETNs' are backed instead by the issuing bank's promise to pay. Therefore, ETNs carry counterparty risk, unlike the competing structures. In the unlikely event the issuing bank declares bankruptcy, ETN holders must stand in line with all other creditors to recover their money.
Unlike ETNs, MLP ETPs organized as C-Corps retain some of the tax-deferment advantages of the underlying master limited partnerships. Most of the cash flows from MLP C-Corps are not taxed as ordinary income, but instead reduce the tax basis of the investor's shares (in proportion to the "return of capital" in the distribution).
The catch is that MLP C-Corps pay taxes at the fund level, an arrangement that sets them apart from ETNs and traditional ETFs. The taxes create the performance wedge seen in Figure 1 comparing the C-Corp AMLP with the exchange-traded note MLPI.
In the rising market of the past 12 months, the C-Corp lags the ETN. But in a falling market, the C-Corp would lose less money. The taxes paid by the C-Corp weaken its exposure to the underlying MLPs, effectively lowering its beta to the index.
Taxation at the fund level also shows up in high headline fees for C-Corps. Funds older than a year must report their estimated deferred tax expense in their headline fee. This explains why a fund like AMLP has an eye-popping total fee of 8.56% despite a management fee of 0.85%. The tax expense varies yearly depending on performance.