Master limited partnerships have garnered a strong following among income investors. However, when investing in a MLP-related exchange traded product, investors should understand the difference between an exchange traded fund and an exchange traded note as the two investment vehicles are not the same.
Both MLP-related ETFs and ETNs track an underlying benchmark index comprised of MLPs. However, the ETFs are structured as C corporations, whereas ETNs are organized as an unsecured debt issued by an underwriting bank.
Unlike other energy sector stocks, MLPs primarily deal with the distribution and storage of energy products, so their business model is less reliant on the commodities market since MLPs profit off the quantity of oil and natural gas they are able to move around. To qualify as an MLP, the companies pass through at least 90% of their income to investors, making the assets an attractive yield-generating investment.
However, since MLP ETFs are structured as a C corp., these corporations are also required to pay corporate income tax on distributions before the distributions are passed through to investors – MLP ETFs are required to pay corporate taxes or a 35% federal rate on returns. Additionally, fund investors are also taxed on the fund dividends and capital-gains distributions.
Consequently, MLP ETF investors may be double-taxed. While it is not an explicit cost, ETF investors would see the results of the corporate tax liabilities through wider tracking error versus the performance of the underlying MLPs.
In contrast, ETNs, unlike ETFs, do not hold physical shares of the underlying companies of the index. ETNs are an unsecured debt security that promises to pay out the value of the index at its maturity, along with any distributions. However, since the note is a debt security, it is exposed to the default risk of the underwriting bank.
Both MLP ETFs and ETN investors are issued a 1099 form instead of the traditional K-1s associated with MLP stocks during tax season. Additionally, MLP ETFs and ETNs can be used in individual retirement accounts without negative consequences, whereas MLP units held in an IRA may be required to pay distributions from unrelated business taxable income in the year it is realized.
For more information on master limited partnerships, visit our MLPs 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.