Helping Clients Navigate Thorny Tax Issues with MLPs

The Alerian MLP ETF (NYSEARCA:AMLP) – the largest exchange traded fund dedicated to master limited partnerships (MLPs) – is higher by nearly 8% year-to-date.

While that figure includes a 13.48% decline over the past month, AMLP’s 2022 showing easily bests that of the bear market-riddled S&P 500 and other broad market benchmarks. Plus, AMLP and comparable products lob off tempting yields, which is relevant to clients at a time when rising interest rates are sapping bond prices. In the case of AMLP, the ETF sports a dividend yield of 10.25%.

In other words, it’s not surprising if advisors are fielding more questions about this income-generating asset class. Advisors should also know that they can add considerable value for MLP-interested clients by helping them navigate the tax issues that accompany this corner of the energy patch.

In fact, many clients probably aren’t aware of the different tax treatments of MLP funds and those differences are meaningful. Hence, the compelling value-add avenue for advisors.

Exploring MLP Fund Tax Treatment

To be clear, the following examines the tax treatments clients can be subjected to when accessing MLP funds. Most investment funds are structured as Regulated Investment Companies (RICs), which are pass-through entities.

Funds structured as RICS –regardless of what the underlying asset class – deliver Form 1099 tax treatment to clients. The rub for the MLP-enthused is that a fund constructed as a RIC can only allocate up to 25% of its assets to MLPs.

It is possible for a fund to be entirely devoted to MLPs, but that in the case, the product is structured as a corporation. As such, the “C-Corp” structure has its own tax benefits and drawbacks.

“The primary attraction of investing in MLPs through a C-Corp fund is achieving diversified exposure with a Form 1099 (no K-1), while enjoying many of the tax benefits associated with direct MLP investment,” according to Alerian research. “The trade-off is the potential tax drag caused by fund-level taxation as discussed below. Distributions from funds typically retain the tax character of the distributions received from their holdings. As such, a C-Corp fund that predominantly owns MLPs will typically provide a higher and more tax-advantaged yield than a RIC. To put it another way, a C-Corp fund is likely to have a greater portion of its distribution be considered a tax-deferred return of capital (reported in box 3 on Form 1099-DIV), with any remainder taxed as a qualified dividend (box 1b on Form 1099-DIV).”

Another avenue for advisors to shine is helping clients navigate a C-Corp’s return of capital distributions and how those distributions affect cost basis.

“An important difference between direct MLP investment and a C-Corp fund is the taxation of basis reductions at sale. As discussed last week, basis reductions are taxed at ordinary income rates with a 20% deduction for investors that own individual MLPs,” adds Alerian. “For investors in C-Corp funds, the difference between the sales price and lowered basis is taxed at the long-term capital gains rate when held for more than a year. Additionally, investors in MLP ETFs or funds do not have to worry about potentially generating unrelated business taxable income in a tax-advantaged account.”

Tax Deferral: Sounds Nice, But..

Another reason many investors and some advisors are drawn to MLPs are tax deferral opportunities. While those can be advantageous, they’re not a free lunch, either.

“When a fund is in a net deferred tax liability status, a 10% increase in the underlying holdings may only result in a 7.7% increase in the fund given a 21% corporate tax rate and approximately 2% for state income taxes. If a C-Corp fund is in a net deferred tax liability status with 23% tax drag, the 20% gain in the fund corresponds to a 26% gain in the underlying holdings,” notes Alerian.

Undoubtedly, clients are drawn to MLPs’ income proposition and with fundamentals in the group strong, the asset class is a viable conversation starter. Clients are sure to have questions and advisors should have the answers.

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