Worldwide Invest Better Day 9/25/2012

The Motley Fool has helped ordinary people become better investors for nearly two decades. This month, we're reaching out to millions of investors to help guide them in their quest toward financial knowledge and independence.

Along those lines, I'm planning to take a look at some different types of investments that many people aren't as familiar with, as well as the popular exchange-traded funds that allow you to make those investments. Today, I'd like to focus on master limited partnerships and the various ways you can invest in them.

Why buy master limited partnerships?
Master limited partnerships combine two of the strongest trends in investing over the past several years. Investments related to energy have skyrocketed in popularity, as new domestic finds of oil and gas using nonconventional techniques like hydraulic fracturing have greatly boosted known reserves and turned once-poor areas of the country into boomtowns almost overnight. Meanwhile, investors prefer investments that pay substantial amounts of income, and if they can get it on a tax-advantaged basis, so much the better.

MLPs are tied to natural resources and typically offer healthy distributions. Moreover, because the assets MLPs own generate substantial tax write-offs for depreciation and other expenses, the distributions that MLPs make typically don't create anywhere near the same tax liability that a similar amount of regular dividend income would cause. Like many MLPs, Energy Transfer Partners (NYSE: ETP) and Kinder Morgan Energy Partners (NYSE: KMP) both focus on the pipeline transmission and storage part of the energy business -- a big growth area, given the far-flung locations where you'll find oil and gas needing transport. And with Kinder Morgan paying a yield of 6% while Energy Transfer exceeds 8%, unit-holders aren't hurting for income.

You can find a few MLPs that cover areas outside energy. For instance, Terra Nitrogen (NYSE: TNH) is structured as an MLP, with its ties to agricultural fertilizers using natural gas as a key raw material for production. One company, StoneMor Partners (NYSE:STON), specializes in funeral-related services yet qualifies as an MLP. For the most part, though, the vast majority of MLPs stick close to the energy sector.

One challenge of MLPs, however, is that because they're partnerships, they come with some tax complexity. In particular, you'll receive detailed K-1 statements with income and deductions, rather than a simple 1099. And with potential state-tax consequences in all the states where an MLP does business, things can get complicated in a hurry.

Are MLP ETFs a smart buy?
Ordinarily, ETFs provide a perfectly acceptable way to buy a diversified set of securities. But MLPs' unusual tax structure creates problems that ETFs can't always overcome.

For instance, take Alerian MLP ETF (NYSEMKT:AMLP). It seeks to get rid of the K-1 problem by letting itself be taxed as a corporation. That allows the ETF to issue simpler 1099 forms, but the tradeoff is that ETF shareholders end up paying the corporate tax that the ETF takes on. That can cost shareholders a whopping 35% of their gains -- a big price to pay to avoid tax confusion.

Meanwhile, to avoid the problems that ETFs raise, another type of product, called the exchange-traded note, can be tied to various indexes of MLP investments. ETNs use a different method to get around the K-1 problem, arguing that because they represent a debt obligation rather than a direct interest in an MLP, the income ETNs generate is interest income that's reportable on a simple 1099. ETNs also don't involve a separate entity and therefore don't raise double-taxation issues. Yet ETNs raise a different danger: default risk. If the company issuing an ETN goes bankrupt, as Lehman Brothers did in 2008, then notes can lose a lot of their value irrespective of what happens to the market they're intended to track.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.