Master limited partnerships (MLPs) gained popularity in recent years as an “alternative” investment. Especially with low interest rates, some investors use MLPs for yield that they can’t get elsewhere (from fixed-income investments in particular).
The problem is that MLPs are not the easiest thing in the world to invest in. So, as you might expect, the financial industry has developed products that are easier to invest in: MLP mutual funds. If you’re wondering what the differences between investing in MLPs directly and using mutual funds, we’ll cover some of the basics here. However, this is just a starting point (to give you a few things to think about) – you’ll need to talk with a tax preparer and financial advisor familiar with your individual situation to figure out what’s best.
Pros and Cons
The main thing to recognize is that there are pros and cons to every decision you make. If you think that MLP mutual funds are better than direct investments (or the other way around) by a long shot, you’ll probably want to do more research. What’s more, these investments might be marketed as replacements for fixed-income investments, but they’re not. MLPs are much riskier than your standard bond portfolio: they are highly concentrated in one industry, among other things. To be fair, they probably won’t suffer in the same way as bonds if interest rates rise quickly, but they are far from risk-free.
MLP Mutual Funds
MLPs are heavily weighted towards energy projects
So what’s the deal with MLP mutual funds? For this article were talking mostly about open-ended mutual funds that invest more than 25% in MLPs (that 25% is a magic number, with certain tax consequences, although mutual funds can invest less than 25% in MLPs) – most people looking for exposure to MLPs focus on these types of funds. Exchange traded notes (ETNs) are different, and beyond the scope of this article.
Easy tax reporting: probably the main appeal of MLP mutual funds is easy tax reporting. You get a 1099, just like you would with any other mutual fund (it is conceivably possible to get a K-1, but it is not frequent occurrence for most investors). 1099 forms are sent out before your tax filing deadline, and they are easy for your tax preparer to handle. Direct MLPs, on the other hand, report with K-1s, which might come out in September of the following year. There’s also a good chance that you’ll have to file income taxes in multiple states if you use direct MLP investments – which increases cost and complexity.
Then there’s the issue of gains. With an MLP mutual fund, dividends do two things: they reduce your cost basis, and they count as income. In general, you might expect roughly 75% of your dividends to be treated as a return of capital (which reduces your cost basis), with the remainder being qualified dividends. After your basis goes to zero, the “return of capital” portion comes to you as a capital gain (ideally long-term capital gains if you’ve held the investment for more than one year).
When you sell an MLP mutual fund, there’s a good chance your cost basis will be near or at zero (because you’re a long-term investor, right?). If so, the majority of the sales proceeds will be treated as long-term capital gains. What if you had a direct MLP investment (which was also at zero basis)? The same thing would happen, but there’s a possibility that you would also have to pay recapture tax, which might mean paying higher rates than long-term capital gains rates.
One last tax benefit of using MLP mutual funds is that you won’t have any Unrelated Business Taxable Income (UBTI) if you’re using certain retirement accounts.
Direct MLP Investing
At this point, MLP mutual funds might be looking pretty attractive. But again, there are always trade-offs.
Double taxation is probably the main drawback of using a MLP mutual fund: earnings are taxed within the fund, passed on to you, and then you pay tax on those earnings as an individual. A mutual fund is a corporation, so it pays taxes at relatively high corporate rates. If you’re interested in using MLPs for income, you’ll get to keep more of it when you use direct investments. As a limited partner, the taxes benefits (and liabilities) flow directly to you.
Which Is Better?
Given all of that, which one is better? It depends. You’ll need to have detailed discussions with your accountant and your financial advisor to discuss the topics below (among others):
- Whether the risk is appropriate for your situation and your goals
- How much less you get to keep from mutual funds after double taxation
- How much more your accountant will charge to deal with tax reporting on direct investments
- Your (or your advisor’s) desire and ability to evaluate and select direct investments or mutual funds
- The liability for UBTI and recapture tax in your situation
- Any alternative ways to meet your goals
Important
While this article mentions tax treatment, it is not and cannot be considered tax advice, and relying on this information will not prevent taxes and penalties (nor will the IRS give you a pass if you show them this article). This article might be inaccurate – you really need to verify this information with somebody who is qualified to evaluate your tax situation individually.
Image credit: Ray Bodden