Unlike owning individual MLPs, the ETF/corporation structure does not have to deal with ordinary income recapture. The main reason it isn’t an issue is because the corporation requires both income and capital gains to be taxed at the same rate.
Passive Activity Losses and Credits
One advantage of an ETF/corporation over a mutual fund or owning individual MLPs is “passive activity losses.” The IRS limits a taxpayer’s ability to deduct losses from businesses in which he or she does not materially participate, also known as passive activity losses. This is to prevent taxpayers from effectively “buying deductions” through investment projects. Investing in an MLP activity is considered a “passive” activity.
With mutual funds or individual ownership of MLPs, the losses and tax credits an investor can claim from passive activity losses is limited. Neither a fund nor an investor is allowed to deduct losses from one MLP to offset gains of another MLP. In fact, the only way to deduct operational losses in an MLP is against gains from the same MLP. This inefficiency leads to losses going unused and more ordinary income recognized.
In contrast, an MLP ETF structured as a corporation avoids the rules regarding passive activity losses. Losses from one MLP can be deducted against any gains incurred by the corporation. This allows the MLP ETF to pool losses from all of the MLPs in the portfolio, and use them to offset gains in other parts of the portfolio, creating a significant potential tax advantage for the ETF.
The ETN Structure
In comparison with the blisteringly complex ETF/corporation structure, exchange-traded notes in the MLP space are phenomenally simple, and what issues they present for investors are quite easily understood.
The MLP ETNs are simply debt instruments issued by a bank, such as J.P. Morgan. The notes promise to mature at a value consistent with a particular MLP index at some point in the future, and to make coupon payments along the way in proportion to the cash distributions of all the MLPs underlying that index.
We can assume that the bank offsets the liability of that promise by actually investing in those very same MLPs, but there’s absolutely no connection between the ETN itself and how the bank chooses to offset that liability—there’s no ownership stake in any MLP at all implied by owning shares of an MLP ETN.
This disconnection simplifies the tax issues surrounding MLP ETNs for good or ill. Investors will owe capital gains taxes on the change in value of the ETN shares when they sell, and they’ll pay ordinary income taxes on whatever coupon payments the ETN makes along the way, just as if they had purchased a J.P. Morgan corporate bond.
While this provides extremely consistent exposure to the total-return characteristics of MLPs, it does so on a pretax basis, and introduces a new source of risk for investors: the risk that the bank issuing the ETN defaults. Because ETNs are just unsecured debt, in the event of bankruptcy, ETN holders could theoretically lose all of their money, just like any bondholder.
The good news is that this risk is relatively easy to analyze; in fact, there’s an entire marketplace devoted to assessing the relative creditworthiness of major banks—the credit default swap (CDS) market.
When credit markets are stable and funding is readily available, this risk associated with daily-tradable unsecured debt from a global bank is generally slim. However, in times of credit stress or in the face of major credit events, this risk is elevated. The chart below shows the one-year CDS rates for all issuers of U.S.-listed ETNs. As you can clearly see, the credit crisis in Europe wreaked havoc on CDS rates for some ETN issuers in 2011.