From the August 2012 issue of Investment Advisor • Subscribe!

The Hidden Tax Burden of MLP ETFs

In an environment of persistently low interest rates, investors have increasingly looked beyond traditional fixed income investments toward other income-producing alternatives. This helps explain the surge in popularity of energy master limited partnerships (MLPs), which offer attractive yields and the potential for dividend growth in the future. There is also a compelling fundamental case to be made for many MLPs, which are benefitting from the renaissance in oil and natural gas production in North America, as demand to transport these fossil fuels continues to grow. Unfortunately, in the process of providing a convenient vehicle for retail investors to gain exposure to MLPs, “pure-play” ETFs and mutual funds may also saddle investors with a hefty, although often unnoticed, tax burden.

Ironically, tax efficiency is one of the attributes to which investors in individual MLPs are often drawn. As long as certain guidelines are followed, individual MLPs’ earnings are not subject to federal corporate income tax. Additionally, a large portion of MLP distributions are classified as returns of capital, which lower an investor’s cost basis and defer taxes until the investor sells the MLP. On the other hand, because of their structure as partnerships, MLPs have additional tax and administrative considerations, of which investors are often wary, such as the requirement to issue a schedule K-1 to investors for each state in which income is received (rather than a single form 1099), as well as the potential for a portion of MLP distributions to be classified as unrelated business taxable income (UBTI), for which there are limits in retirement accounts.

One of the most important questions investors should consider when evaluating the many ways to invest in MLPs is how well each investment matches up with his or her investment goals. For pure-play MLP ETFs and mutual funds, the benefits of investing in MLPs come with a steep cost.

In order for an ETF or mutual fund to qualify as a regulated investment company (RIC), there are certain requirements it must meet. One such rule limits ETFs and mutual funds from investing more than 25% of the fund’s portfolio in MLPs. If an ETF or mutual fund exceeds that threshold, it does not qualify as an RIC, and is therefore classified as a C corporation. As such, the fund is subject to federal corporate income tax, currently at a maximum rate of 35%, in addition to potential alternative minimum tax and state income tax liabilities.

In other words, because of its classification as a C corporation, for every dollar that a non-RIC MLP fund earns, there is a 35-cent “tax drag” that is included in the calculation of the fund’s daily net asset value (NAV). This results in a mere 65-cent gain for investors in the fund (ignoring additional fund fees and expenses, which further reduce the NAV). Since these calculations are reflected in the fund’s NAV, many investors are simply unaware that their earnings have been effectively reduced by this tax liability.

Of course, corporate tax liability is a known element that is embedded in the price of most stocks, as taxes provide the same sort of drag on the earnings of individual companies. The difference when it comes to MLP ETFs and mutual funds, however, is that the market value of the underlying MLPs does not generally reflect the embedded tax drag investors are saddled with as owners of the fund. Instead, fund investors effectively pay a premium for the tax-advantaged income generated by MLPs, without realizing the benefits, which are offset by the fund’s tax liability as a corporation.

As is often the case, the devil is in the details when it comes to investing in MLPs via exchange-traded funds. As evidenced by more than $3 billion of inflows over the past few years, many investors have found these funds to be convenient vehicles by which to gain diversified exposure to a compelling asset class. Few, however, have fully understood the cost incurred for that convenience. While MLPs may add value to an ETF if the fund’s allocations are limited to less than 25% (allowing the fund to maintain its RIC-eligibility), the built-in tax burden for exceeding that threshold is too detrimental to fund returns to be overlooked.

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