Investors that are income hungry and seeking yield have been attracted to MLP exchange traded funds recently. The benefits of these funds may outweigh the risks, but it is worth taking the time to be aware of pitfalls with master limited partnerships as they are complicated.

“MLPs are focused in the ‘midstream’ energy sector, meaning the processing and transportation of energy commodities. These companies own and operate the pipelines that deliver gas and liquids across the country, as well as the storage facilities and processing plants that bring product to market,” Abby Woodham wrote on Morningstar. [MLP ETFs for an Income Stream]

MLP ETFs have much possibility for capital appreciation, a high yield and diversification benefits in an investment portfolio. However, there are various tax characteristics that these investments have that can have an unfavorable impact upon a portfolio. [MLP ETFs: A Pipeline for Yield for Your Portfolio]

The uncommon tax treatment of these ETFs is what investors should be aware of. At tax season, owners will receive a complicated K-1 form instead of the usual 1099, and they may have to file in every state the MLP operates in. Those paying for tax services “by the pound” may find the excess return of MLPs wiped out by costs. Furthermore, costs can outweigh benefits in a retirement account due to unrelated business taxable income that MLPs are synonymous with. [Yield Hunters Get More MLP ETFs]

ALPS Alerian MLP ETF (NYSEArca: AMLP) has about $4 billion in assets. The Investment Company Act of 1940 forbids open-end funds from owning more than 25% of their portfolio in MLPs, AMLP is structured as a C-corporation and pays income tax at the corporate level. Any taxable income they receive from the underlying MLPs is an annual tax liability, and upon the sale of the portfolio’s shares, they must also pay up at the corporate level. Functionally, investors are being taxed twice.

As long as interest rates remain low, MLPs will be able to cheaply finance new projects and grow, reports Woodham.


Tisha Guerrero 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.