With 2019 coming to a close, investors have to start thinking about taxes and ways they can minimize their tax burden if they haven’t done so already. One place to look is ETF products that can take advantage of the tax benefits of master limited partnerships (MLPs).
“MLPs do not pay taxes at the entity level if 90% or more of their income is from qualifying sources which are defined in the Internal Revenue Code to include exploration and production, transportation, and other activities involving any mineral or natural resource, an Alerian research report noted. “This benefit allows MLPs to return more of their cash flow to investors in the form of a distribution. Unlike a corporation, an MLP’s income, deductions, credits, and other items flow through proportionally to the unitholder as a limited partner.”
“These items are detailed each year on a Schedule K-1 sent to the investor,” the report added. “The flow-through status of MLPs also holds on the state level, meaning MLP investors are required to pay state income taxes on their allocated portion of income in each state in which the MLP operates. It’s important to note that some states do not require you to file state tax returns unless your gross income exceeds a certain amount, which could reduce the number of required state filings. While K-1 forms result in extra work for investors (or their accountant), the pass-through benefit allows MLPs to avoid the double-taxation associated with investments in C-Corporations.”
Unincorporated Business Entities
ETFs structured as a partnership are unincorporated business entities so they are not subject to the double taxation of a corporation. If the partnership does not elect to be taxed as a corporation, then it also benefits from pass-through taxation so any realized gains and losses flow directly to investors in the fund.
Partnerships are flexible in terms of the types of investments they can make. Unlike grantor trusts, partnerships can invest in other types of commodities like oil or natural gas due to their flexibility.
However, ETFs structured as a partnership falls under the regulatory measures of the U.S. Commodity Futures Trading Commission. As such, these ETFs are subject to reporting and other financial disclosures.
To improve tax efficiency, MLP-related ETFs limit exposure to MLPs to 24% at each quarterly rebalance. Traditional MLP funds that hold more than 25% of their portfolios in MLPs are structured as C-Corporations and must pay corporate income tax on distributions before passing them on to investors, which incurs additional tax headaches come tax season that translates to lower overall returns.
One ETF to consider is the ALPS Alerian MLP ETF (NYSEArca: AMLP), which seeks investment results that correspond generally to the price and yield performance of its underlying index, the Alerian MLP Infrastructure Index. The index is comprised of energy infrastructure MLPs that earn a majority of their cash flow from the transportation, storage, and processing of energy commodities.
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