The Right Way to Integrate MLPs In Client Portfolios

Just a few days removed from Tax Day, advisors are likely tired of tax talk and understandably so. However, the topic is always relevant, particularly when it’s directly applicable to a high-flying asset class.

That’s the case with master limited partnerships (MLPs) and midstream energy assets. The Alerian MLP Infrastructure Index is up nearly 26% year-to-date. Adding to the best of both worlds feel of MLPs, that index yields 7.53%. Both data points are dominant over supposedly safer bonds and broad equity strategies.

However, there are tax complexities associated with MLPs that many clients are aware and these issues are all the more relevant for advisors that are deploying MLPs in client portfolios in fund form.

Here’s the easy explanation to use with clients: An exchange traded fund or mutual fund that devotes more than 25% of its weight to MLPs will be taxed as a corporation, but funds that go up to but not beyond that 25% limit maintain pass-through status.

More MLP Tax Talk

An MLP-heavy fund does offer the potential for tax-deferred income, but there’s also a strong possibility of tax drag, which clients aren’t likely to be fond of.

“Most investors are likely familiar with investment vehicles like mutual funds and ETFs that are Regulated Investment Companies (RIC) under the Investment Company Act of 1940. RICs are pass-through structures, acting as a conduit of income and gains to the end investor,” according to Alerian research. “RICs must meet certain criteria, including a diversification test. In order to maintain their pass-through status, RICs cannot have more than 25% of their assets in MLPs. A fund that owns more than 25% MLPs will not be treated as a pass-through but rather will be taxed as a corporation.”

The debate between RIC-compliant and C-Corp midstream energy funds is similar to nearly any market conversation: There are trade-offs. With the RIC-compliant structure, a fund may have more diversification and better long-term return prospects. However, the C-Corp option has its own perks.

“MLPs offer the potential for tax-deferred income and tend to provide higher yields than their counterparts organized as corporations. Investors wanting to maximize tax-advantaged income will likely favor C-Corp MLP ETFs, which provide higher, tax-advantaged yield by nature of their greater exposure to MLPs,” adds Alerian.

Not the Worst Trade-Off

Still, the trade-off isn’t  always bad. For example, the Alerian Midstream Energy Select Index, which caps MLP exposure at 25%, is performing admirably this year. In fact, it’s up nearly 26% and it yields a tidy 5.53%.

“O pen- and closed-end funds may own up to 25% MLPs to maintain their pass-through status as RICs but holding more than 25% MLPs will result in the fund being taxed as a corporation. Funds that predominantly hold MLPs offer the potential for tax-deferred income but may experience tax drag as underlying holdings gain. RIC-compliant MLP funds have lower yields by nature of the 25% cap on MLPs but can appeal to investors seeking total return or diversified midstream exposure,” concludes Alerian.

At the end of the day, C-Corp funds are arguably more versatile in that they don’t create headaches in retirement accounts, but RIC-compliant funds are suitable in discretionary accounts held by income-hungry investors.

Related: Dial Up Dividend for Income, Protection