Over the last few weeks I've written a number of articles on Master Limited Partnerships (MLPs). The articles received overwhelming readership and over 1,000 comments. It was my purpose in writing the articles to explore the merits of MLPs solely on a tax basis.
It was my position that MLPs offer only illusionary tax benefits and all things being equal, the tax benefits and income stream can be replicated and improved through traditional stock ownership.
I really didn't go into too much detail on MLPs in IRAs and Roths as most investors have become aware of the tax drag (UBIT) associated with investing in MLPs in tax deferred accounts.
Just to be perfectly clear, I don't discount MLPs as investment vehicles. My conclusions were simply that the current tax regulations present a drag and not a plus. As such, anyone considering an MLP as an investment should adjust their expectations to account for this drag. Now, after making such an adjustment, if they determine that the potential reward exceeds the risks, by all means go ahead.
In response to my articles, many SA readers asked for or offered alternative ways of owning MLPs. For IRAs, I favor using options and intend to explore that in a separate article. In this article, let me explore two alternatives offered by readers:
1) ETFs such as the Alerian MLP ETF (NYSEARCA:AMLP), and
2) ETNs such as JP Morgan MLP Index ETN (NYSEARCA:AMJ)
Alerian MLP ETF
In keeping with my prior articles I'm not going to discuss whether one should/shouldn't invest in MLPs or this or any other ETF. I just want to focus on the tax issues and present some information that investors' may overlook.
First, these ETFs purchase a basket of underlying MLPs, and make distributions which are considered either dividends (eligible for LongTermCapitalGain, if qualified) or ReturnOfCapital. Because no part of these distributions is income from the MLPs, but, rather, from the ETF, there is no ordinary income tax or UBIT incurred by the shareholders. This can be very attractive to investors, seemingly avoiding the tax problems highlighted in my previous articles.
Not so fast. The ETF itself incurs the income and pays tax at the corporate tax rate. Depending on how large their income, it could be taxed anywhere between 15% and 39%. This tax is subtracted from the amount available for distributions, so the net income the shareholder receives may be less than if they owned the shares outright.
The Devil in the Details: The bane of MLP taxation is the "recapture tax." Well, you say, at least I don't have that to worry about. Well, not necessarily. AMLP charges NAV for projected taxes on income that was deferred, in short, "recapture tax" (page 22, prospectus). As a result, the fund incurs this liability right off the bat and when any MLP is sold and any recapture tax is due, just offsets this liability. In essence, the shareholders NAV is being charge TODAY, for a FUTURE event.
The saving grace? Many stocks and ETFs don't trade at NAV. The share price is determined by supply/demand. So, even though this "recapture tax" is assessed against NAV, it may not, currently, show up on share price. In effect, today's shareholders may be paying a premium over NAV without even knowing it.
Back in 2013 I wrote an article and concluded that as investors became aware of the tax implications in MLPs that the demand would fall off and some price correction would occur. Now, it's impossible to quantify the extent to which this may have happened in the recent slide, but my guess is some of the slide is because of reduced demand as a result of investor awareness.
If this theory holds true, then as investors become aware of the tax and accounting issues at the ETF level, this "premium" will dissipate and shares will correct, somewhat to reflect reduced demand.
JPMorgan MLP Index
ETNs characteristically DO NOT buy the underlying Index. In fact, an Index is ethereal and no one can buy it. The best one can do is try to replicate it. This can be dome by actually buying the underlying securities and rebalancing as appropriate or using various derivatives.
Since there are no investments in MLPs, the tax features of MLPs are not present -- no recapture, no ROC, no k-1, no UBIT.
There are two downsides to ETNs. The first is distributions are considered ordinary income, not dividends. That sort of rules them out for taxable accounts, but is NOT a negative for IRAs and ROTHS.
However, the second downside is that the "asset" that the investor owns is little more than a promissory note from the issuer (i.e., JPMorgan) to pay the investor the appropriate amount. Theoretically, JPM could take the investors' money, invest in something unrelated to MLPs and bet that their investments will outperform their obligations under the ETN. Though it's not a Ponzi scheme, and is heavily regulated, it shares some of the motivations and obligations.
Since the investor is nothing more than a general creditor of the issuer, some solvency risk is evident. JPM is not likely to be stressed (again, remember 2008) but one should assign at least some level of risk. Additionally, using ETNs from less well capitalized issuers (i.e., NOT TBTF) should be scrutinized.
Summary: A MLP is a tax structure, not a sector. If one wants to invest in a sector, they have many companies and ETFs to choose from. Many MLPs are in the energy sector and certain of those companies and sub-sectors may be oversold as a result of the PPB oil rout. If so, they would be attractive investments.
My series of articles are just a cautionary note to investors that they should discount companies operating as MLPs because tax benefits in MLPs are illusionary and are actually a drag. Look to the strength of the company, not its structure.
Conclusion: For those that want to invest in the sector, they can consider alternate ways of avoiding DIRECT tax issues. However, using ETFs may actually expose the investor to indirect taxes in excess of direct taxes. The benefit to an ETF is diversification NOT tax avoidance.
Turning to ETNs, they work well in IRAs and Roths, and avoid any and all tax issues surrounding the MLPs themselves. If you can assume the solvency risk, they can also be engaged as a diversification tool.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.