A Hassle-Free Path to MLP Investing?

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These days, many investors need as much investment income as they can find. Master limited partnerships have gained popularity in recent years precisely because they deliver lucrative income streams to their investors -- and often come with valuable tax benefits.

But even as we close the books on another tax season, the shortcomings of owning MLP units will likely remain on the minds of unitholders for some time. Below, I'll talk about some new exchange-traded funds that hope to get rid of those tax nightmares for good. But first, let's take a look at MLPs and the pros and cons of investing in them.

Feel the energy
High oil prices and a booming supply of natural-gas drilling have made oil and gas investments extremely popular. Many energy stocks feature attractive yields as a result, especially those focusing on oil and other liquids, where prices are particularly high.

But many energy companies pay huge amounts of taxes, offsetting their profits and reducing how much they have available to pay dividends. One way to get a tax advantage is to invest in what's known as pass-through entities, of which MLPs are an example. Because they qualify for favorable tax treatment, MLPs don't have to pay taxes like corporations do. They instead have to tell their unitholders what their respective share of each MLP's income is, and the investors then have to report that income on their own individual tax returns.

Avoiding the double taxation of being a corporation is a definite plus for MLPs and their investors, as well as the impact lower taxes have on their yields. Inergy (NYSE: NRGY  ) with its massive 18% yield is definitely extreme even for MLPs, but with more sustainable yields in the 7% range, Linn Energy (Nasdaq: LINE  ) and Energy Transfer Partners (NYSE: ETP  ) still pay enough to top most conventional energy investments. But the downside is that the way that MLPs have to report their income to their unitholders -- using the infamous Form K-1 -- creates a huge accounting headache that can require multiple tax filings in various states as well as added complications on your federal return.

The ETF "solution"
Late last year, I wrote about how Alerian MLP ETF (NYSE: AMLP  ) aims to solve the problem of K-1 tax reporting. By taking on full corporate status rather than the typical registered investment company structure that most ETFs use, Alerian MLP ETF is able to treat its investors as regular shareholders rather than MLP unitholders, and thus it doesn't have to send out K-1s or create big tax complications. But there's a huge downside: As a regular corporation, the ETF has to pay taxes -- and those taxes have greatly reduced the returns the ETF has produced over its history. Since the Alerian MLP ETF's inception, its tracking index has returned more than 21% per year -- but the ETF shares themselves only had a return of 13%.

The new ETFs that focus on MLP investment use the same corporate structure as their Alerian counterpart. Both Global X MLP ETF and Yorkville High Income MLP ETF include provisions in their prospectuses that discuss the potential impact that their corporate tax liability will have on their net asset values, so it's reasonable to conclude that they'll face similar return shortfalls.

Pick your poison
Of course, even 13% annual returns sound pretty good in the current market environment, so you might be inclined to say that saving the tax hassle is worth it. Moreover, the tax impact also acts as a brake on declines as well, as it allows the funds to reduce their tax reserves.

But the complications are just another way that investors can get surprised by complex investments. Just as United States Natural Gas (NYSE: UNG  ) has failed to track the long-term changes in the spot price of natural gas, so too has the Alerian MLP ETF failed to match the returns available on MLPs. In all likelihood, the new ETFs will face the same problem.

MLP ETFs save you from tax hassles, but at the severe cost of a big tax hit. Before you invest, you have to decide whether reduced returns are worth the convenience that MLP ETFs provide.

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Fool contributor Dan Caplinger hates hassles. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is always hassle-free.

Read/Post Comments (7) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 23, 2012, at 12:32 PM, SpaceVegetable wrote:

    What about entities like MLPY and AMJ? Do those still have the K-1 hassle? Also, with MLPs themselves, is it possible to find out in advance which states would require tax filings? I already own a small holding in AMLP, but am looking to add more MLP and royalty trusts to my portfolio. I'd like to fully understand the tax issues before doing so, however.

  • Report this Comment On April 23, 2012, at 12:56 PM, techpatriot wrote:

    Is it possible to hold this ETF in a tax advantaged retirement account (IRA) without negatvie tax consequenses ? I understand there is a big problem holding MLPs within an IRA.

    Is there anyway to easily and legally invest in MLPs inside of an IRA?

  • Report this Comment On April 23, 2012, at 1:29 PM, CluckChicken wrote:

    You will have to speak to a tax professional to get accurate answers to those questions.

    What I can answer for you is what states would need the K-1. All that the MLP operates in. So for example KMP operates in 37 states, so if you hit the treashold and need to file the K-1 you will have to do so in the 37 states it opperates in plus whatever states you normally need to file with.

    If looking to add an MLP some have additional stocks. Kinder has KMI which functions like a standard stock with dividends but has a much lower yield then KMP does. They also have KMR which has a quarterly stock split in place of a dividend that nearly matches the payout rate of KMP.

  • Report this Comment On April 23, 2012, at 4:30 PM, TMFGalagan wrote:

    @SpaceVegetable -

    Exchange-traded notes are debt instruments and so they don't have K-1 issues.

    @techpatriot -

    As corporations, I believe one of the benefits of these ETFs is that they don't produce unrelated business taxable income that can cause problems in an IRA.

    @CluckChicken - Thanks for the info!


    dan (TMF Galagan)

  • Report this Comment On April 23, 2012, at 5:16 PM, robandcindy2 wrote:
  • Report this Comment On April 23, 2012, at 8:15 PM, nm10066 wrote:

    THERE IS AN EASIER WAY; simple buy your MLP's in a ROTH IRA. No taxes or reporting period. One exception: non business related income which must be if you are paid over $1000.00 in the tax year, which I have never seen for all the MLP's I've bought in my ROTHS.

  • Report this Comment On April 23, 2012, at 8:38 PM, JustTheFacts814 wrote:

    All this moaning about K-1s is silly nonsense. One buys Turbotax software. Then one copies the data from the K-1s to numbered boxes in the Turbotax software. Sure it’s boring, but anyone with any IQ over 50 can do it. Anyone that can’t copy the numbers to the TT software should not be an investor. Find someone you trust to tell you what mutual funds to buy. Or just put the money in a bank savings account at 0.5% interest!

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