How to Get MLP Exposure Without a K-1 or UBTI

• MLP/midstream investment products can help investors access the MLP space without the potential headaches of a Schedule K-1.
• Products can mitigate some potential risks with midstream investing and help avoid Unrelated Business Taxable Income (UBTI) for tax-exempt organizations and retirement accounts.
• Investors have a number of products from which to choose, including active and passive strategies and different vehicles like ETFs, ETNs, and mutual funds.

Investors are often attracted to the MLP space for its generous yields but may be deterred by the prospect of Schedule K-1s. Directly investing in an individual MLP is often the most tax-efficient approach but will result in the issuance of a Schedule K-1 for filing taxes. Investors can get MLP exposure without the hassle of a K-1 by using investment vehicles like ETFs, exchange-traded notes (ETNs), and mutual funds. This piece discusses some of the benefits of accessing MLPs through investment vehicles and provides a brief overview of the MLP/midstream product landscape.

Note that this article is not intended to be tax advice. For more on directly investing in MLPs, please view our MLP Primer.

A key attraction of accessing the MLP space through an ETF, ETN, or mutual fund is the ability to receive a Form 1099, instead of a Schedule K-1. Beyond K-1 avoidance, there can be other benefits of accessing the space through an investment product.

For example, products can provide exposure to multiple companies in one vehicle. This allows investors to avoid single-security risk and also helps mitigate midstream-specific risks like recontracting. This refers to the risk that a midstream provider is unable to renew contracts at the same or better terms when long-term agreements expire. By owning a portfolio of MLPs, investors are less exposed to the recontracting risk for a specific pipeline or asset. Risks from a certain counterparty or producing region are also less pronounced in a portfolio of MLPs compared to owning individual names.

Investment products can also help avoid UBTI for tax-exempt organizations and retirement accounts. In short, these entities must pay tax on UBTI (i.e., income that is not related to their tax-exempt purpose) if total UBTI exceeds $1,000. When an investor holds an MLP in their IRA, the IRA is a partner in the MLP, and its business (e.g., operating pipelines) is not related to the account’s tax-exempt purpose. The income from the MLP is therefore treated as UBTI (read more).

While investors can own individual MLPs in tax-advantaged accounts, it may be suboptimal and could result in owing taxes in an otherwise tax-exempt entity. Notably, MLP ETFs, ETNs, and mutual funds do not generate UBTI. (Note that there is a risk of UBTI if the tax-exempt entity owns the securities using debt financing.)

There are two main types of midstream investment products — those focused on MLPs and several more that only own up to 25% MLPs for tax reasons.

Looking specifically at exchange-traded products, midstream energy infrastructure is the energy subsector with the most investment products available. This includes nearly a dozen energy infrastructure ETFs structured as Regulated Investment Companies (RICs), which only own up to 25% MLPs (read more). The other 75% of RIC funds is typically allocated to U.S. and Canadian midstream corporations or utilities. RICs tend to have lower yields than MLP-focused products, given that MLPs often have higher yields than C-Corps.

There are three MLP-focused ETFs. The Alerian MLP ETF (AMLP A-) was the first MLP ETF and is the second-largest energy ETF overall. ETFs, mutual funds, or closed-end funds (CEFs) that own more than 25% MLPs are taxed as corporations. These investment products tend to appeal to investors that are primarily seeking yield. As of May 30, the Alerian MLP Infrastructure Index (AMZI) was yielding 7.6%. These funds can experience tax drag when their underlying holdings are gaining, but the tax treatment can also provide a downside buffer when equities are falling (read more).

Investors can also access the MLP space through exchange-traded notes (ETNs). ETNs are unsecured debt obligations of an issuer that agrees to pay the return on an index. One of the main benefits of ETNs is minimal tracking error, but the drawbacks can be the credit risk of the issuer and the taxation of coupons at ordinary income (read more). ETNs tend to be most suitable for tax-exempt accounts for this reason. There are five midstream ETNs, four of which are focused on MLPs and track an Alerian index. The largest of these is the JP Morgan Chase Alerian MLP Index ETN (AMJB B-), which tracks the Alerian MLP Index (AMZ).

Investors may prefer to access the MLP or broader midstream space through active or passive products. Investors should consider the exposures provided by products, their fees, and historical performance compared to benchmarks. (Of course, past performance is no guarantee of future results).

Investors may also take into consideration the niche nature of the midstream space, particularly for MLPs. With a limited number of energy infrastructure MLPs and corporations, it is arguably difficult for active managers to generate alpha from security selection. Simply put, there are only so many investable companies to choose from. Admittedly, there is clear bias here given that VettaFi is an index provider.

MLP/midstream investment products can help investors avoid a Schedule K-1, while providing other potential benefits as well. Investors have several options when it comes to accessing the MLP/midstream space through products.

AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB). AMZ is the underlying index for the JPMCFC Alerian MLP Index ETN (AMJB), the ETRACS Alerian MLP Index ETN Series B (AMUB), and the ETRACS Quarterly Pay 1.5x Leveraged Alerian MLP Index ETN (MLPR).

ETFs, CEFs & More: MLP Investment Products Evolve

Why Most MLP ETFs Own Less than 25% MLPs

MLPs and UBTI: What Advisors Should Know

MLP ETNs 101: What Advisors Should Know

Primer: Investing in Energy Infrastructure MLPs

vettafi.com is owned by VettaFi LLC (“VettaFi”). VettaFi is the index provider for AMLP, MLPB, AMJB, AMUB, and MLPR for which it receives an index licensing fee. However, AMLP, MLPB, AMJB, AMUB, and MLPR are not issued, sponsored, endorsed, or sold by VettaFi. VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of AMLP, MLPB, AMJB, AMUB, and MLPR.

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