What is an ETF? — Part 30: Master Limited Partnerships

Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 29: Bank Loans]

Master limited partnership, or MLP, ETFs provide investors with an added layer of diversification and additional income generation.

While MLPs are associated with the energy sector, they have a low correlation to energy prices, along with the broader equities markets, as the assets act like a toll-road in the nation’s energy infrastructure. However, MLP ETFs have certain tax pitfalls investors need to be sure to avoid. [Morningstar Warning on MLP ETF Taxes]

MLPs build, acquire and operate transportation assets. While investors link MLPs with energy, specifically natural gas and crude oil, they are more involved with transporting the commodities. Consequently, the performance of MLPs is less dependent on commodity prices than on how much of the commodity is pushed through. [MLP ETFs in Focus After Sell-Off on Yield and Dividend Taxes]

For instance, the MLPs would exact the same toll on oil pumped through their pipelines if crude oil cost $50 dollars a barrel or $100 dollars a barrel.

With MLP funds, investors would not have to fill out the individual K-1 forms come tax season and would, instead, receive a simple 1099 form. However, MLP ETFs will come with corporate taxes for capital gains inside the ETF. According to U.S. federal law, MLP ETFs, which are registered as a regulated investment company, cannot have over 25% of its portfolio in MLPs. As such, MLP ETFs fall under a C-corporation designation and will incur capital gains taxes.

As a partnership, MLPs act as a pass-through entity where the company’s income or losses pass through to individual owners of the partnership. In contrast, in the ETF corporation structure, investors will experience a double taxation where the corporation pay corporate income tax and then again when dividends are paid out.

On the other hand, MLP exchange traded notes do not come with capital gains taxes, and they also do not require K-1s. However, ETNs are debt securities subject to the creditworthiness of the issuer. Additionally, after-tax returns may be lower on ETNs than for ETFs since ETNs payments are treated like fixed-income assets. [Exchange Traded Notes (ETNs)]

For qualified accounts, like 401(k)s and IRAs, investors should use MLP ETFs, whereas individuals may incur taxes on unrelated business taxable income, or UBTI, which is what MLP income is considered, in these accounts down the road. Nevertheless, we are not accountants, and potential investors should still consult their tax experts.

MLP ETFs include:

• ALPS Alerian MLP ETF (AMLP)

• First Trust North American Energy Infrastructure Fund (EMLP)

• Global X MLP ETF (MLPA)

• Yorkville High Income MLP ETF (YMLP)

MLP ETNs include:

• JP Morgan Alerian MLP Index ETN (AMJ)

• Credit Suisse Master Limited Partnerships ETN (MLPN)

• Morgan Stanley Cushing MLP High Income Index ETN (MLPY)

• UBS ETRACS Alerian MLP Infrastructure ETN (MLPI)

• UBS ETRACS 2xMonthly Leveraged Long Alerian MLP Infrastructure ETN (MLPL)

• UBS ETRACS Alerian Natural Gas MLP ETN (MLPG)

• UBS E-TRACS Alerian MLP Index ETN (AMU)

• UBS ETRACS Wells Fargo MLP Index ETN (MLPW)

• UBS ETRACS 1xMonthly Short Alerian MLP Infrastructure TR* ETN (MLPS)

For past stories in this series, visit our “What is an ETF?” category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.