EQUITY AND FIXED-INCOME FUNDS
MLP ETFs are entirely unique in the world of exchange-traded funds, and require an entirely different approach to analysis because MLP ETFs forfeit the tax benefits accorded traditional ETFs by bringing into play the two levels of tax associated with U.S. C-corporations.
The core issue with MLP ETFs is that, while they were created in an attempt to pass through distributions in the same tax form as received from the MLP, they do so by adopting the double tax structure of a regular U.S. C-corporation and thereby interfere with the traditional pass-through mechanism that MLPs were designed to enable (as well as the single tax mechanism applicable to traditional ETFs). Rather than allowing income to pass directly through from the MLPs to shareholders, they insert a tollgate at the corporate level where MLP and appreciation are taxed and then a second “exit” tax is levied at the investor level.
A Primer on Partnerships
Each unit holder in a partnership such as an MLP is allocated a proportionate share of the partnership’s income, gains, deductions, losses and credits. For individual investors holding individual MLPs, any income, gains, deductions, losses and credits are passed through directly and taxed at the individual investor’s tax rate. With the MLP ETF, however, all income and gains are pooled and taxed at the same corporate rate inside the ETF, as a pure expense of the fund.
On the bright side, and unlike individual MLPs, neither MLP ETFs nor ETNs issue K-1 partnership statements at the end of the year, which can help investors avoid tax-deadline headaches. K-1s can be mailed to investors as late as March 15, forcing many investors to resubmit their taxes with last-minute changes. Furthermore, investors in individual MLPs are forced to file tax returns in every state where that MLP earned income, and any unrelated business income within an MLP could potentially change previously nontaxable income to taxable in the current year. Needless to say, this can cause enormous chaos for an individual’s tax situation if things go badly.
Capital Gains and Losses
Because the corporation underlying an MLP ETF is the named owner of each MLP in its portfolio, the MLP ETF will accumulate capital gains and losses on any MLPs that are sold in the course of redemptions or any rebalancing of the portfolio. While traditional ETFs are widely seen as tax-efficient vehicles because they have “pass-through” characteristics and they can minimize capital gains by “passing out” low-basis shares of securities when redemptions occur, the C-corporation structure is a different animal entirely because it is not a “pass-through” and it cannot pass out low-basis property.
In fact, MLP ETFs will generate a capital gain or loss subject to immediate taxation every time a redemption takes place. That said, there have been very few redemptions in the Alerian MLP ETF (AMLP) to date, so the impact of this has been muted. In a corporate structure, capital losses have a five-year time span in which they can be carried forward to offset gains. In a perfect world, an MLP ETF would be managed so as to only generate realized capital losses to the extent of capital gains—essentially aiming for capital gains and losses to perfectly offset each other. While this is unlikely in the real world, the ETF manager does have some control over this in the right environment.
It is important to point out that these capital gains aren’t passed on to the ETF investor, however. AMLP has never paid a capital gains distribution and likely never will. Because of the corporate structure, these capital gains from redemptions or rebalancing are recognized and taxed at the maximum corporate tax rate of 35%. Corporations do not enjoy the lower tax rate for long-term capital gains that individuals enjoy.
Because of this, the management of losses to offset gains by the ETF manager is critical, as the expiration of a capital loss carry-forward leads to an eventual recognition of a “phantom” gain and significant tax burden. Let’s take a simple case: