With many investors looking for income wherever they can find it, master limited partnerships have attracted a lot of attention lately as a tax-smart way to boost your portfolio income. But as many MLP investors undoubtedly found out over the past month, navigating your way through the tax complications can challenge even the savviest of taxpayers. Now, though, there's an alternative that retains many of the tax advantages of MLPs without the fuss at tax time.
Understanding master limited partnerships
As my colleague and fellow Fool Dan Dzombak aptly described earlier this week, master limited partnerships involve an unusual legal structure that you'll most often see in the energy industry. In contrast to the more standard corporate structure that most publicly traded companies use, MLPs pay no taxes of their own. Rather, they pass their tax attributes, including income and deductions, directly through to the holders of the limited partnership units that you can buy and sell on major stock exchanges.
The benefit of MLPs is that because the energy business is highly capital-intensive, deductions related to capital assets, such as depreciation, can be quite high compared to the amount of income the business generates. But because the depreciation is only an accounting figure, the MLP has much more cash on hand than its taxable income would suggest. So when you look at major MLPs such as Kinder Morgan Energy Partners (NYSE: KMP), Cheniere Energy Partners (AMEX: CQP), and Buckeye Partners (NYSE: BPL), you'll see that investors get distributions that are more than double the taxable income they generate. In some cases, as with Linn Energy (Nasdaq: LINE), a tax loss means that none of your distributions would get taxed.
But these tax advantages come with a price to pay. MLPs have to file taxes as partnerships, which means that rather than getting a nice and simple 1099 form listing your dividends at the end of the year, you'll get stuck with a long, complicated partnership tax information return known as a K-1.
Enter ETFs
As if we didn't have enough three-letter acronyms in the investing world, one possible solution to the MLP tax problem comes from exchange-traded funds. Until recently, the only exchange-traded products that owned MLPs were structured as notes, which had the disadvantage of eliminating some of the tax benefits that MLPs gave their investors.
But the Alerian MLP ETF (NYSE: AMLP), which became available last year, is a true ETF. Interestingly, though, just as MLPs differ from regular corporations, the Alerian ETF also has a different structure from most ETFs.
In particular, the Alerian ETF isn't set up as a registered investment company. That means that rather than passing through its taxable income to investors, the Alerian MLP will pay taxes at the corporate level as an independent entity.
In most cases, that would be a bad thing, as it would result in double taxation for shareholders. But with MLPs, the double-taxation problem hasn't yet materialized, because the ETF gets the benefits of the favorable tax treatment of the money it receives from its MLP investments -- and so the dividends the ETF in turn pays its shareholders have also been treated as returns of capital rather than taxable income. And, most importantly, the structure of the ETF ensures that shareholders get a regular 1099 at the end of the year rather than K-1s from each of the ETF's holdings.
With many popular MLPs under its umbrella, including Enterprise Products Partners (NYSE: EPD) and Magellan Midstream Partners (NYSE: MMP), the Alerian ETF has a reasonable mix of interesting investments. It won't let you drill down on particular operations, but for many, the diversification and tax simplicity may be worth it.
Keep it simple
So if you've thought about investing in MLPs but don't want the tax hassle, take a closer look at the Alerian ETF. You may find that it gives you exactly what you're looking for to take advantage of the benefits of MLPs.
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