MLP ETF vs. MLP ETN: An Overview
The main difference between a master limited partnership (MLP) exchange-traded fund (ETF) and an MLP exchange-traded note (ETN) is the tax consequence for distributions from each asset. Both MLP ETFs and ETNs track an underlying MLP index.
- Both MLP ETFs and ETNs track an MLP index, but their distributions are taxed differently.
- MLP ETNs tend to track the underlying index better than MLP ETFs because the MLP ETF is structured as a C-corp, which leads to double taxation—taxes paid at the corporate level and by the individual on dividends received.
- An MLP ETN is structured as an unsecured debt where the distributions are considered taxable income, however.
- While the tax benefits are better when investing directly in an MLP, using an MLP ETF or MLP ETN avoids having to file a K-1 tax form, and they can be held in individual retirement accounts (IRAs) without negative tax consequences.
MLP Exchange-Traded Funds (ETFs)
MLP ETFs are often structured as C-corporations. Before paying distributions to investors, corporations pay a corporate income tax, which reduces the performance of the ETF. One of the distinct advantages of MLPs is their pass-through taxation structure, where there are no taxes paid at the partnership level, thus avoiding the double-taxation issue. By paying corporate taxes for the ETF structure, this benefit is negated. This means the MLP has a significant tracking error versus the performance of the underlying MLPs.
MLP Exchange-Traded Notes (ETNs)
The MLP ETN is organized as unsecured debt issued by a bank, which tracks the MLP index. This avoids the payment of corporate taxes and leads to better tracking. The drawback to this structure is distributions are treated as taxable income, which has certain tax consequences.
With an outright ownership interest in an MLP, distributions are not taxed as ordinary income at the time received. Rather, these distributions are considered reductions in the cost basis of the investment. Any taxes on distributions are deferred until the interest in the MLP is conveyed. Due to the significant depreciation and other tax deductions of MLPs, distributable cash flow is often higher than the taxable income, creating efficient tax deferral.
Most MLPs are in the energy sector due to certain restrictions Congress placed on the use of the MLP structure in 1987. These MLPs often have large capital investments in gas and oil pipelines and storage, which realize depreciation on a yearly basis.
If the MLP interest is transferred to the heirs of the holder, the cost basis of the MLP units is adjusted to the value as of the transfer date. This eliminates any tax liability caused by the return of capital distributions made previously. This can be a strong estate planning tool if used correctly, and it is not available to those who own the MLP stock directly instead of in an ETF or ETN.
Both the ETF and ETN allows investors to avoid filing a K-1 tax form. A K-1 is required for distributions received from the outright ownership of an MLP. Many investors find filing a K-1 complicated. Unitholders are considered owners in the business since they are limited partners.
In addition, the MLP ETFs and ETNs may be held in individual retirement accounts (IRAs) without negative tax consequences. The IRS defines distributions from MLPs as unrelated business taxable income that must be paid in the year it is realized if MLP units are held directly in an IRA. This cancels out the tax-deferred advantages of MLP distributions. Thus, there may be advantages to the ETFs and ETNs for investors who want MLP investments in their IRAs.