Master limited partnerships provide attractive yields due to the way they operate but come with a number of tax issues. Investors, though, can look at a few MLP exchange traded funds that help limit the tax hassle.
MLPs are publicly traded partnerships known for their “pass-through” feature that help investors generate stable, predictable cash flows, writes Paul Baiocchi for Forbes. Additionally, distributions are largely tax deferred.
Investors, though, are required to pay income taxes in states where the MLP operates and have to report taxes on the K-1 form.
With MLP ETFs, investors won’t have to bother with the K-1 form and will have to fill out the normal form 1099.
However, MLP ETFs that hold more than 25% of their portfolio in MLPs are structured as C-Corporations in order to track an underlying MLP-related index. Due to the C-Corporation structure, they must pay corporate income tax on distributions before passing them to investors. Consequently, MLP ETFs may incur higher fees that would cut into overall performance, leading to an underperformance compared to the underlying benchmark. [A Closer Look at Master Limited Partnership ETFs and ETNs]]
Exchange traded notes, on the other hand, removes the corporate-level taxation problem and better reflects the full performance of the underlying index. The ETN, though, is an unsecured note issued by an underwriting bank and is taxed as ordinary income. [The 411 on MLP ETFs & ETNs]
First trust recently came out with the actively managed First Trust North American Energy Infrastructure Fund (NYSEArca: EMLP), the first RIC-compliant MLP product that doesn’t dilute the tax benefits of holding individual MLPs. However, by limiting MLP holdings to 25%, the ETF includes other energy infrastructure firms with similar characteristics to MLPs.
Additionally, the newer Global X MLP & Energy Infrastructure ETF (NYSEArca: MLPX) also limits holdings of MLPs and includes a basket of energy infrastructure stocks to eliminate the corporate-level taxation associated with C-Corporation ETFs. [Global X’s New MLP ETF Attempts to Avoid Tax Bite]
For more information on master limited partnerships, visit our MLPs category.
Max Chen contributed to this article.