To summarize, you should own the ETN if:
- The investor expects the majority of total return to come from price appreciation.
- The investor is using a tax-deferred account and cannot benefit from the tax deferral of the ETF structure.
- The investor has a shorter time horizon.
- The investor places a high value on transparency and predictable returns.
- The investor is unconcerned about the credit risk of the note.
- The investor is more concerned with total return than after-tax yield.
An ETF/corporation makes most sense for MLP exposure if:
- The distribution yield of the MLP is greater than or equal to the MLP index total return. In this case, the tax deferral overwhelms the performance hit of the internal tax issues; however, paying out a higher distribution than total return is likely unsustainable in the long run.
- The investor has a very long time horizon, including potentially passing her position to an estate.
- The investor uses a high discount rate to value future cash flows.
- The investor has a low tolerance for credit risk.
- The investor is comfortable with complex tax accounting and its associated risks.
- The investor values tax efficiency over absolute returns or index tracking.
ACCESSING MLPS: EVALUATING THE OPTIONS
Master limited partnerships are required to be in specific businesses to qualify for MLP status. They can engage in the production, processing or transportation of oil, natural gas and coal. They also produce, process or transport natural gas liquids, or are in the business of wholesale propane distribution. Many MLPs are unique in the energy space. Consider a pipeline company. It can often be shielded from changes in the price of energy, instead making money based on the quantity of material that travels through their pipelines, regardless of the actual price of that fuel. Some MLPs even earn revenues simply from keeping their transportation systems running, regardless of the amount of oil, natural gas or coal transported, further insulating them from changes in the demand for, or price of, energy. Investors often come to MLPs just for these insulating factors, as they help to ensure a steady and often high stream of income, without the variability that comes from traditional energy investments or alternative high-dividend-yielding equities.
MLPs tend to offer investors large dividends, and on an individual MLP level, they do so in a tax-efficient structure.
The reason is that an MLP, at its core, is a pass-through entity: Income generated from operations is passed through to shareholders directly, as if that shareholder had personally earned that income, with no corporate-level taxation. It is similar both to REITs and the now-extinct Canadian royalty trust structure. In fact, shareholders in an MLP are quite literally legally treated as “partners,” and the MLP itself is structured as a limited partnership. The limited partnership passes income directly through to investors in the same form in which it was received by the partnership, allowing income to be taxed only once, on the individual investor’s tax filing. In other words, MLP income is taxed as ordinary income on shareholders’ tax returns; capital gains on equipment sold is taxed as capital gains; and so on.
Like any business, however, MLPs get to write off business expenses and depreciate capital expenditures, such as the cost of building a pipeline in the first place. These deductions offset the operating revenue of the MLP; thus, distributions of cash flow are often treated as nontaxable return of capital. The MLP owner gets a distribution, and lowers the cost basis of its investment, but pays no current taxes on that distribution. In recent years, it has been typical for between 70 and 100% of MLP distributions to be this kind of nontaxable return of capital, creating an extremely tax-efficient investment. While the investor must eventually pay taxes on the amount that this cost basis was reduced, they will do it at some time in the future, not now. It’s important to note that those future taxes won’t necessarily be at capital gains rates, due to “ordinary income recapture” rules, described later in this document; however, in general, a significant portion of those future taxes will be at the lower capital gains rate, except in cases where the cost basis has reached the zero bound.