MLP Funds & Other Alternatives To Direct MLP Ownership

In this section,we cover products that provide alternatives ways to invest in MLPs besides directly owning units of specific companies. For those who want some MLP exposure without directly owning the units, these products generally offer an imperfect tradeoff of return in exchange for simplicity, which many may still find worthwhile.

Their advantages include:

  • Simplified tax reporting and payment for US individuals using non-tax advantaged brokerage accounts, or tax advantaged retirement accounts which might be subject to avoidable unrelated business income tax (UBTI) liabilities.
  • Allow MLP exposure for funds of persons with legal or other restrictions that may limit or prohibit direct MLP ownership
  • Greater liquidity because many MLPs are thinly traded compared to the more popular MLP funds
  • Those same advantages associated with investing via funds or other wrapper instruments instead of direct investment in specific equities or debt instruments, including:
    • Flexibility: they can be held in virtually any kind of account or fund
    • Greater diversification with a smaller position and thus minimizing risk of loss from trouble at any single MLP
    • Save time, effort of researching, monitoring investments and leaving that work to professionals

Disadvantages generally include:

  • A likely lower return than one would get from direct investment in a selection of MLP units of comparable value and quality, as most of these MLP products incur added tax at the entity level, a loss of tax deferrals, and management fees. Indeed there is little disagreement that if an individual US investor can hold MLPs directly via a taxable account, that’s the best way to own them from a tax perspective.[i] Many MLP funds also don’t track their underlying index well, resulting in share price underperformance
  • Added risk from funds using leverage, or from ETN credit risk. ETNs, as debt instruments, have credit risk because their value can decline with the credit rating of the issuer, or disappear in case of issuer insolvency.

Let’s look at these advantages and disadvantages in greater detail, so that you’ll better understand whether or not these alternatives to direct MLP investment may be relevant for you.

Why Some Prefer to Avoid Direct Ownership

The most common reasons fall into the following categories.

For Same Reasons Investors Use Funds Rather Than Direct Investment

First, the MLP funds appeal to investors who in principle prefer investing via mutual or exchange traded funds, or ETNs, to direct investment in specific shares. These reasons boil down to simplicity, diversification, and the likelihood of comparable or better performance.

Simplicity: Fund Simplifies Selection, Monitoring, and Taxation

As covered in depth in Selection Criteria, there’s considerable variation in the risk profile and growth prospects of different MLPs, even among those in the same business. Also the character and risk level of a given MLP can change over time, due to changes in the character of the MLPs activities, governance risks, company specific events, etc. Valuation metrics are different for comparing MLPs to each other and to other investments. Actively managed funds not only relieve the investor of all the added work and expertise needed for selection and monitoring MLP investments, in theory the professional fund managers should do these tasks better.

Diversification

As with any other fund, even a small investment eliminates single company risk because you’re buying a basket of companies.

Comparable Or Better Performance Regarding Share Price Appreciation

Given the added simplicity and diversification, as long as one believes that the fund can offer comparable performance, why not go with the fund? After all, most stocks move up and down together anyway, most investors don’t outperform the indexes, and professional selection and monitoring should in theory be as or better than that of most part time amateurs.

In sum, the simplicity, diversification, and professional management advantages may well compensate for the likely lower annual cash distributions from directly owning a comparable basket of MLPs.

MLP-Specific Reasons For Avoiding Direct Ownership

There are MLP-specific reasons why different kinds of individual or institutional investors might prefer investing in MLPs via MLP funds or other MLP products.

The short version: tax complications.

In general, these involve avoiding the tax reporting and payment complications that stem from the MLP’s pass through status and from potential unrelated business income tax (UBTI).

Here’s what we mean.

As we discussed in Part 2, a shareholder in a corporation is a part owner of a separate, taxable legal person. In contrast, an MLP unit holder is the taxable entity, a limited partner. A corporate shareholder receives a share of after tax income in the form of dividends, which are purely a form of investment income. In contrast, an MLP unit holder gets a share of actual business income (as well as expenses). As we wrote in Part 2:

The (MLP) unitholders are the sole taxable entity of the MLP. They are the direct recipients of their share in the business’s income, its tax benefits, and liabilities that come with these benefits. Unitholders are thus responsible to report and pay federal taxes as well as state taxes in every state where the MLP operates and they owe tax above any minimal exempt amount.

Let’s review the specific reasons for different kinds of investors to avoid direct MLP investment.

Individual Investors

This group may prefer to use the MLP products (mutual funds, ETFs, ETNs, etc) in order to avoid one or more of the following (all covered in Part 2, on MLP distribution taxation):

  1. Tax reporting and payment complications: MLPs are tax advantaged investments that come with more complex and demanding tax reporting requirements. These include.
  2. The need to keep track of changing cost bases: Usually only about 20% of each quarterly distribution is taxable income and taxed in that year at ordinary rates, the rest is a tax deferred return of capital which is subtracted from one’s cost basis. The cost basis of each separately purchased lot of the same MLP must be tracked separately.
  3. Changing tax rates on distributions: If accumulated returns of capital reduce your cost bases to zero for a given lot, all future distributions that exceed taxable income are now taxed at capital gains rates, which are typically the same as those for qualified dividends.
  4. Possible Double Taxation At Time of Sale: If investors sell those units during their lifetime, a portion of those distributions that were taxed at capital gains rates (after cost basis was reduced to zero) will be taxed again, this time at ordinary income rates (called recapture). The difference between purchase price and sale price will still be taxed at capital gain rates. See Part 2 on MLP distribution taxation for an example of this.
  5. Possible tax reporting and payment in multiple states: If your share of taxable income earned from an MLP’s operations in a given state exceed the state’s minimum annual taxable income, you must file a tax return in that state and may owe state tax. This is unlikely to be a problem until you’ve a substantial position (high five figures or more) in the MLP.
  6. Additional tax reporting and payment complications if holding MLPs in retirement accounts: As covered in Part 4 on MLPs and retirement planning issues, tax reporting and payment complications, including potential additional tax from unrelated business income tax UBIT, may outweigh the yield advantage of direct MLP ownership in retirement accounts for some investors.

Institutions

Tax advantaged pension funds may prefer indirect investment for the same reasons as those with IRAs or other retirement accounts as covered in Part 4 (tax reporting and UBTI issues in particular). However MLPs’ strong performance over the past decade has brought some pension and endowment funds to make direct investments in MLPs as part of their long term holdings. For example in 2011 the Missouri Teachers Association, a pension fund, and the UT Investment Company (University of Texas at Austin), and endowment fund, both made direct investments in MLPs.

Most however, simply prefer alternative products as a means of avoiding the time and money costs from the added tax reporting complications of direct MLP ownership.

Mutual Funds

The tax rules limit traditional mutual funds (organized as a 1940 Act Regulated Investment Company (RIC) to owning less than 10 percent of any single MLP, and to having no more than 25 percent of the mutual fund’s total assets invested in MLP securities (equity and debt). If a mutual fund organized as a RIC exceeds either limit, it loses its passthrough status for federal income tax purposes, and thus is taxed as a corporation.

In order to avoid these restrictions and hold 100% of its total assets in MLPs, many mutual funds have organized as regular c-corporations. However this structure has its own disadvantages as discussed below.

The desire (or need in the case of certain kinds of funds like RICS) to avoid those tax payment and reporting issues, on both a federal and state level, as well as the potential complications of having “business income,” is what drives many investors to invest indirectly in MLPs through a variety of MLP products discussed below.

MLP Products: Pros And Cons Of Each

Below we compare and contrast the alternatives to direct MLP investment.

None are panaceas. In exchange for avoiding some or all of the potential tax payment and reporting responsibilities, these products typically have significantly lower annual distributions than you’d get from owning a comparable basket of MLP units, and they lack some or all tax advantages.

Some of these MLP products also have their own unique risks, which we’ll cover below.

The huge caveat here is that this can only serve as a general guide, given the number of material variables that could influence your final after tax return. These include:

  • Anticipated holding period
  • Management performance and fees for a given product
  • In the case of an MLP’s own in-house corporate version of itself, the performance of the underlying MLP
  • A surprising degree of uncertainty about the ultimate tax treatment of different kinds of income and expense items in different kinds of funds
  • The degree of risk added by certain kinds of products. For example certain kinds of funds use leveraged trading, which amplifies both gains and losses from trade outcomes. Exchange traded notes (ETNs) bear the credit risk of the issuer, so their value could fluctuate along with the issuer’s credit rating.

Closed End (Mutual) Funds (CEFs) Structured As Taxable C-Corporations

The first funds to circumvent the above RICS restrictions came out in 2004. They were closed-end funds that structured themselves as C-corporations rather than the traditional 1940 Act open-end funds. As such they could be 100% invested in MLP units and received the full range of pass-through tax benefits like any other unit holder at the corporate level. As corporations, however, they then pay taxes on these, and withhold some of that after tax income to pay fees and anticipated future expenses like deferred MLP taxes. They pay out the remainder as a corporate dividend to investors, along with a regular 1099 form. Investors then pay tax on that income, usually at qualified dividend tax rates.

Like any other closed end mutual fund, these issue a fixed number of shares. The price of these shares varies with demand, so their price can be above or below their net asset value (NAV), the actual value of the MLP units they hold.

Both the advantages and disadvantages come from their corporate structure.

Their advantages (in addition to those of any fund like diversification and professional management):

  • Simple Tax Reporting: The fund owns the units and is the limited partner. It thus reports and pays tax at the fund or corporate level. After setting aside some of that after tax income for its own fees and for future taxes owed on deferred portions of distributions, the fund pays a regular corporate dividend to shareholders and issue 1099s to report that income like any other corporation.
  • Simple Tax Payment, No UBIT Issues: Direct business income has already been taxed at the corporate (fund) level, and so comes as dividend income. Thus any income from these funds is not business income and thus avoids any of the UBIT issues that can incur additional tax liabilities for retirement accounts or other tax exempt entities.

Their disadvantages:

Lower Yields: Relative to a comparable basket of MLP units, their after tax yields tend to be lower due to a combination of fund fees and loss of tax efficiencies from the direct pass through of income, expenses, and varying degrees of tax deferrals, to investors.

Lower Net Asset Value Relative To A Benchmark Index Or Basket Of Units Held: Unlike the MLPs they own, these funds must bear the burdens imposed by the very corporate structure that simplifies ownership. These include:

  • Tax at corporate level
  • Fund Administration Fees
  • The need to set aside yet more cash for future deferred tax liabilities

So these funds struggle to match the returns of their basket of MLPs that they hold. One way they do that is by using leverage, which adds risk.

Added Risk From Use of Leverage: Usually, an MLP fund can pass along some MLP tax benefits to shareholders within the dividend, allowing them to defer taxes as if they owned the MLPs directly.[ii] However any capital gains earned from the fund’s trading activities cut the percentage of the fund’s dividend that can be treated as a tax deferred return of capital. To compensate, closed end funds usually use leverage, which can indeed boost returns but also adds risk of greater losses if the leveraged trades don’t go as planned.[iii]

Open End Mutual Funds Organized As Taxable C-Corporations

Unlike closed end MLP mutual funds, which have been around since 2004, these only appeared in 2010. As open ended funds, they have no limit on the amount of shares issued, and trade at their net asset value (NAV). Otherwise, they share the same basic mix of advantages and disadvantages compared to direct MLP investment as closed end funds, though they haven’t been as popular as closed end funds, ETFs, or ETNs. Like any open ended fund, it must buy and redeem the underlying shares, or units in this case, as investors buy and sell shares in the fund. This administrative burden can add to fees. Also, instead of buying and selling them through your broker like a closed end fund, you buy and sell directly from the fund itself.

MLP Mutual Funds Subject to RICS Regulations

There are also both closed and open end MLP mutual funds, organized as non-taxable “M” corporations, which are subject to RICS regulations that limit their total direct MLP unit holdings to 25% of total funds. The rest is invested in a mixture of MLP related instruments like MLP debt, corporate subsidiaries, other MLP funds, as well as assets that are similar to those of MLPs like shares in energy infrastructure or utility corporations.

The unique disadvantage with these is that your exposure to actual MLPs is limited to 25% of the total assets. These are not taxable at the corporate level (which in theory should free up cash for distributions) yet still pay in dividends and so simple dividend income tax reporting. These exist as open and closed end mutual funds and also as ETFs, but are in all cases less popular than their c-corporation counterparts that have 100% MLP exposure.

Exchange Traded Funds (ETFs)

Relative to holding a comparable basket of MLP units directly, these offer a mix of advantages and disadvantages similar to that of the CEFs above, but they tend to have lower fees. That’s due to a great extent to their being simpler to manage than mutual funds. They aren’t trying to actively trade in order to beat an index. They’re only trying to passively track an index.

Advantages Over Direct MLP Ownership: Like the other MLP wrapper products, they offer the same simplified tax reporting and payment, and avoid UBIT issues.

Disadvantages: Overall return is similarly reduced from a combination of fees and a loss of the MLP tax efficiencies to varying degrees stemming from their corporate structure.

These include:

  • Tax at corporate level, and again at investor level
  • Fund Administration Fees
  • The need to set aside yet more cash for future deferred tax liabilities on the tax deferred potion of their MLP distributions.

These same burdens may cause MLP ETFs to lag their benchmark index (typically one of the Alerian MLP indexes), and they’ll have an added risk to the extent that they use leverage.

Deferred Tax Liabilities, Assets, Distort NAV, Limit Index Tracking Ability, Appreciation

Also, their ability to track their benchmark index is limited by another factor unique to these MLP ETFs. Because they’re organized as tax paying c-corporations, they must accrue deferred tax liabilities and assets that occur whenever their positions in their underlying units show gains or losses, because as taxable corporations, MLP ETFs must theoretically pay deferred tax liabilities or receive deferred tax deductions if the ETF ever terminates. Their quoted NAV includes these unrealized gains and losses.

In contrast, the benchmark indexes, and the NAVs of regular ETFs, don’t include such variables. Regular ETFs are not taxed at the entity level, and so need not accrue unrealized gains and losses because they’ll never pay taxes on them. If these ever become realized gains or losses, standard ETFs just distribute any realized gain or loss directly to their shareholders, who then pay any tax owed.

If that was clear, then skip the next three paragraphs. For the tax-accounting “challenged,” here’s a more detailed explanation.

Unrealized gains occur within an MLP ETF just as they do in your own portfolio, whenever the value of an MLP exceeds its cost basis but the fund has not yet sold the MLP. Unrealized losses are incurred whenever the value drops below the cost basis. Given that most of the quarterly distribution includes a net return of capital that reduces the cost basis in an MLP position, most MLP positions in the ETF are either in a state of unrealized gain (much more likely) or unrealized loss (possible if enough taxable income and decline price from time of purchase). From a tax accounting viewpoint, this means the fund always has an accrued deferred tax liability for all unrealized gains (because they might need to be paid in the future) and a deferred tax asset for all unrealized losses (which at that future time could bring tax deductions or refunds) that have accumulated in the fund.

Although these are hypothetical future tax payments and deductions, which would be paid only upon termination of the ETF, these deferred tax assets and liabilities are updated daily for the daily calculation of NAV. Thus the NAV is constantly gaining or losing value based on the daily changes in estimated future tax owed at some hypothetical future time.

In sum, MLP ETFs have to include these deferred tax liabilities and assets in their NAVs because they are tax paying corporations that might one day need to pay or receive these deferred liabilities and benefits. In contrast, standard ETFs, like the indexes they track, are not taxed and thus need not make such adjustments to their NAVs. Thus MLP ETFs don’t track their benchmark indexes as well as other ETFs, or as well as MLP ETNs, as we’ll explain below.

Why Likely Under-Tracking Of NAV Matters

MLP distributions are constantly reducing cost basis, so the it can be assumed that MLP ETFs are carrying far more deferred tax liabilities (tax owed) than tax assets (tax refunds or deductions owed them). That means MLP ETF investors must absorb reduced NAV that may detract from the share price and thus from the benefit of having some deferred tax on a portion of the MLP ETF’s distributions.

ETFs vs. Mutual Funds

Similarities: Like mutual funds, they own a basket of MLPs, and circumvent the 25% RIC holding rule noted above by structuring themselves as c-corporations. Both are taxed at the corporate level and pay dividends out of that after tax income, which is again taxed at dividend tax rates when received by investors.

Advantages:

  • Like ETFs in general, MLP ETFs these tend to have lower fees than mutual funds, as they are simply trying to mimic an index rather than outperform it via active trading.
  • The difference in structure between c-corporation MLP mutual funds and c-corporation MLP ETFs allows ETFs to avoid the passive activity loss rules that prevent mutual funds (and direct investors in MLPs) from pooling losses from different MLPs and using them to offset gains from other MLPs, creating a potentially important tax advantage for the ETF.[iv]

MLP ETFs vs. Other Kinds of ETFs

As noted above:

Traditional ETFs, pay out income currently received from shares held, take a tax deduction for those payouts, and thus reduce or eliminate corporate tax at the ETF level.

In contrast, MLP ETFs are unique to other ETFs because they’re specifically organized as C-corporations in order to spare investors the tax reporting and payment complications that can be unacceptable to certain kinds of investors noted above.

That c-corporation organization not only reduces after tax returns from double taxation and the need to withhold even more cash for possible payment of deferred taxes, it also causes MLP ETFs’ to understate their NAV and thus not track their benchmark index well. That can mean their share price appreciation is lower than that of their index.

That said, the majority of at least some MLP ETF dividends have in fact been eligible to be treated as return of capital distributions, much like their underlying MLPs. For example, the Alerian MLP ETF (AMLP), the most popular MLP ETF, has had 85% or more of its distributions eligible for this tax deferred treatment in 2011, and 99.7% of them eligible in 2012. However, as with direct ownership of MLPs, that up-front tax deferral probably comes at a price of higher and/or double future taxation.[v]

Exchange Traded Notes (ETNs)

As their name implies, ETNs are indexed-linked notes, debt instruments, rather than baskets of actual MLP units that comprise a given index. These notes pay coupons linked to the distributions of the MLPs that are tracked in an underlying index (again, usually one of the Alerian MLP indexes), minus any fees. In other words, you’re lending money to the ETN issuer in exchange for payments that mimic that of an index of MLPs. All differences between ETNs and ETFs (as well as mutual funds) flow from that essential difference.

Tax Reporting

Both MLP funds and ETNs issue greatly simplify tax reporting compared to direct MLP ownership and issue simple 1099s instead of partnership K-1s. However the below difference in taxation create some minor reporting differences.

Here’s a rundown of those differences.

Tax Payment

ETNs and funds (mutual and ETF) handle tax payments differently, so each investor would need to evaluate which instrument would offer lower tax payments.

  • ETN income is treated like a bond coupon, and thus taxes at ordinary income tax rates in the year owed. However unlike most MLP funds or other alternative MLP investments that are organized as c-corporations, there is no entity level tax. Like a bond coupon, the ETN payment is taxed only once at the investor level.
  • In contrast, MLP ETFs and mutual funds
    • Hold 25% - 100% MLP units, and from these pay out dividends that are typically taxed at lower qualified dividend rates
    • May pass along to investors at least a degree of tax deferrals or other benefits, directly or indirectly.
  • ETN’s Avoid Capital Gains Until Sold: Appreciation in the MLP index is deferred and taxed at capital gain rates when the MLP ETN is sold or matures.
  • ETNs preserve some of the tax advantages of direct MLP ownership because capital gains are deferred until the ETN is sold, at which point appreciation is taxed at lower capital gains rates.

Different Risks: ETNs Have Credit Risk

Perhaps the biggest potential disadvantage of ETNs is that, as unsecured debt instruments, they expose investors to credit risk of the issuer. In other words, because the ETN is a debt note, its value can drop if the issuing bank’s credit rating falls, or even disappear if the issuer becomes insolvent. On a daily basis, the market’s assessment of that risk is baked into the ETN’s price. Although the maturity of the available MLP ETNs is at this time over 10 years, credit exposure is limited to a one-week rolling basis.

Fortunately that credit risk is easy to isolate and measure. Simply check the credit default spread (CDS) market to see how the issuer stands. CDSs are essentially insurance policies one buys against default by a given party. The ‘spread’ is the cost or yield demanded by the issuer, compared to the cost of a given low risk benchmark. The narrower the spread, the lower the risk.

As of this writing the most popular MLP ETN is the JPMorgan Alerian MLP index ETN (AMJ), so investors are subject to the credit risk of a JP Morgan default. Default risk is real but minimal, especially for those who believe the US government would backstop big too-big-to-fail issuers or their insurers (like AIG) to prevent systemic risk. Still, as we mentioned in Part 4, such rescues are not guaranteed. Just ask the folks who used to work at Lehman Brothers Bank.

In contrast, MLP funds have no issuer credit risk. However, like any equity fund investment, they are exposed to the credit risk of the underlying companies.

Different Risks: Mutual Funds, ETFs ETNs, Have Varying Leverage Risk

Some of these products use leverage, which amplifies, (or reduces) both rewards and risks, and can cause material tracking errors of the instrument’s underlying index, as has been the case with the Alerian MLP ETF (AMLP).[vi]

ETNs Track Their Underlying Index Better

MLP ETFs organized as C corps have higher tracking errors than ETNs, mostly because they’re burdened with a combination of expenses that ETNs don’t have:

  • Taxation at the fund level
  • Setoffs for future tax payments: MLP ETFs must also set aside funds for future payments on currently deferred taxes

Fees: ETN Fees Lower Than Those of ETFs, Mutual Funds

Mutual funds tend to have the highest fees of any of the MLP funds, ETFs have lower fees than mutual funds, and ETNs have the lower fees than the funds.[vii]

Conclusion on ETNs

Overall, here’s how ETNs compare with ETF and mutual funds that are organized as C-corporations

  • Advantages
    • Better tracking of underlying indexes than ETFs
    • Lower fees than any fund
    • No double taxation
    • No hidden leverage risk
  • Disadvantages
    • No direct or indirect pass through of tax deferrals
    • Credit Risk

MLP’s Own Publicly Traded Corporations

In order to get a share of the capital flowing into alternative MLP products, a few MLPs have set up their own publicly traded corporations whose only assets are their shares in parts of the company. Typically they own only units of the MLP itself, except for KMI, which mostly owns a share in KMP’s general partner. Two of these corporate MLP offshoots, Kinder Morgan Management, LLC (KMR) (from KMP) and Enbridge Energy Management, LLC (EEQ) (from EEN) pay dividends in additional a form of equity called “I-shares” rather than cash.

Two others, one from KMP called Kinder Morgan Inc. (KMI) and another from Linn Energy (LINE), called Linn Co., LLC (LNCO) do pay cash dividends.

Taking them as a group, here’s how they compare to direct MLP ownership. Again, it’s mostly a tradeoff between higher absolute returns vs. avoiding tax reporting and payment issues.

Advantages

Tax Reporting And Payment Simplicity: All issue 1099s and generally avoid the tax reporting and payment complications like K-1s and UBTI. This makes them more easily held by institutions, and foreigner, as well as retirement accounts, for reasons we discuss in part six. It’s possible that growing demand from these deep pocketed sources could provide a boost to their share prices that MLP units would miss. Most of these are designed so that the share price should closely track that of the underlying MLPs. In certain cases, such as KMI, share price might exceed the MLP share price because it owns shares in the general partner rather than the MLP. When the general partner is doing better than the MLP, KMI should also outperform KMR, which owns shares in the MLP itself.

Disadvantages

Higher Taxes

Annual after tax yields suffer because they are taxed at the entity level, and again at the shareholder level, and miss much of the other tax advantages of direct MLP ownership. However if these are held in tax deferred retirement accounts, there is little or loss of the tax deferral advantage. Also, KMR and EEQ payment of dividends in shares might not appeal to everyone.

Like other corporations holding MLP shares, they need to set aside funds to pay future taxes on distributions that are currently tax deferred, as well as on any possible recapture on distributions that were taxed at capital gains rates after years of returns of capital reduced cost basis hit zero, if the corporation needs to sell long held units

Same Company-Specific Risk As Direct Ownership

These companies hold only the units of the own MLPs, and so lack the diversification of the funds or ETNs, and are exposed to company specific risks.

KMI At Risk Of Future Distribution Cut?

For example, while KMR, EEQ, and LNCO derive their value from their share in ownership and cash flows of the MLP as limited partners, most of KMI’s value is based on its ownership of KMP’s general partner. This is relevant because that GP is one of the elite few that have grown cash distributions to the point that it merits a full 50% of the company’s available cash distributions via its incentive distribution rights (IDRS, discussed in Part 3). This high claim on cash flow places a heavy burden on KMP’s ability to grow LP distributions. Per Morningstar, KMP needs to grow its distributable cash flow by 10% annually in order to keep LP distributions growing at 5%, which appears to be an unrealistic expectation.[viii] Annual LP distribution growth for KMP has been flat-to-lower in recent years and is expected to stay that way, at about 4.5% per year. Meanwhile the GP’s distributions are expected to grow at about twice that rate. There have been repeated calls for KMP management to voluntarily reduce or eliminate its IDRs, as several other MLPs have done in recent years. There is a real risk of that happening. That’s the biggest risk to KMI’s long term growth.

Conclusion

As noted earlier, there are many variables to weigh in deciding which form of MLP ownership provides the best overall return.

Here are just a few that could radically alter whether one chooses to invest in MLPs, and if so, how.

  1. Individual US investors focused primarily on overall return may well opt for direct investment. As noted in part 4, as long as MLPs continue to outperform competing income investments in terms of both annual income and capital appreciation, that may be true even for those holding them in retirement accounts, despite the tax reporting and payment complications.
  2. Those more sensitive to the tax reporting and payment complications, or those faced with specific legal restrictions, may opt for the alternative wrapper products or MLP-specific corporate variants.
  3. The choice also depends on a variety of assumptions about the future. For example
  4. Future prospects for specific MLPs and their sectors, the energy sector and the various parts of its value chain( upstream, midstream, and downstream) and the assorted business models within each of these. Remember, the odds favor the big players in this capital intensive field, but even they will be challenged to continue to outperform other investments if their industry suffers a downturn.
  5. Future credit risks of major ETN issuers
  6. Your personal investment needs: If you plan on leaving certain MLPs to your estate and don’t anticipate high estate taxes, you would not be concerned about a large tax at ordinary rates from recapture, nor would you be concerned about these units being subject to estate taxes at their stepped up basis when transferred to your estate. Others who foresee selling MLPs units to fund a retirement would want to calculate the ultimate tax they might pay upon sale.
  7. Alternatively, one might believe that MLPs’ overall return will justify and ultimate tax payment, if one assumes:
    • Interest rates will remain low for many years to come, so MLP yields remain exceptionally rewarding
    • The US dollar will continue its multi-decade slide against most major currencies and in 10-20 years any tax paid will be in dollars that are worth far less than they are today
  8. It’s also a matter of your views on what the future has in store for:
    • MLPs as an asset class and whether their returns will continue to justify the added tax reporting and payment burdens of holding them directly
    • Specific sectors and specific MLPs within those sectors
    • Performance of specific funds
    • Credit risk of specific ETNs

In sum, the alternative MLP wrapper products seem to forfeit most or all of the tax and income advantages of MLPs in exchange for the tax reporting and payment simplicity of a dividend-paying stock. Thus you or your accountant must consider whether there are any advantages to holding MLP funds compared to holding the stocks of corporations in the same industries.

Given what appears to be similar income yields, the deciding factor may just be whether or not one believes that MLP units will appreciate more than the shares of a comparable natural resource corporation.


[i] http://mlpguy.com/archives/957:

“It should be noted that everyone agrees – including…, Kenny Feng (President & CEO of Alerian, the publisher of Alerian MLP indexes) – that if you can own MLPs directly, that’s the best way to own them from a tax / tax shield benefit perspective. But if you can’t own MLP directly, the bottom line is that in order to get rid of the K-1 and UBTI issues and to get passive exposure to the sector, there are tradeoffs that often mean reduced returns.”

[ii]http://www.naptp.org/documentlinks/Investor_Relations/MLP_101.pdf, slide 69

[iii]http://online.barrons.com/article/SB50001424052748704235404578404631782560640.html?mod=BOL_twm_col, also, Midstream Energy MLPs Primer, Maresca, Santiago, Kad, McIntosh, Morgan Stanley, January 12, 2011, p.10

[iv]http://www.indexuniverse.com/sections/white-papers/16413-the-definitive-guide-to-mlp-etfs-and-etns.html?showall=&fullart=1&start=11

Passive Activity Losses and Credits

One advantage of an ETF/corporation over a mutual fund or owning individual MLPs is “passive activity losses.” The IRS limits a taxpayer’s ability to deduct losses from businesses in which he or she does not materially participate, also known as passive activity losses. This is to prevent taxpayers from effectively “buying deductions” through investment projects. Investing in an MLP activity is considered a “passive” activity.

With mutual funds or individual ownership of MLPs, the losses and tax credits an investor can claim from passive activity losses is limited. Neither a fund nor an investor is allowed to deduct losses from one MLP to offset gains of another MLP. In fact, the only way to deduct operational losses in an MLP is against gains from the same MLP. This inefficiency leads to losses going unused and more ordinary income recognized.

In contrast, an MLP ETF structured as a corporation avoids the rules regarding passive activity losses. Losses from one MLP can be deducted against any gains incurred by the corporation. This allows the MLP ETF to pool losses from all of the MLPs in the portfolio, and use them to offset gains in other parts of the portfolio, creating a significant potential tax advantage for the ETF.

[v] http://www.indexuniverse.com/sections/white-papers/16413-the-definitive-guide-to-mlp-etfs-and-etns.html, The Definitive Guide to MLP ETFs and ETNs, Baiocchi, McFadden, and Nadig, IndexUniverse.com, 2013

[vi] http://www.thestreet.com/story/10870678/1/alerian-mlp-etfs-little-secret.html

[vii] http://online.barrons.com/article/SB50001424052748704235404578404631782560640.html?mod=BOL_twm_col

[viii] http://www.istockanalyst.com/article/viewarticle/articleid/4883818