Master Limited Partnerships (MLPs) are inexorably linked with those annoying K-1s in the minds of many investors, complicating tax reporting. For some people it’s one of the few things they know about MLPs and the muttered warning of their accountants to avoid K-1s keeps them away from the asset class. Direct holdings of MLPs are the most efficient way to invest in the sector, and in my experience the K-1s aren’t that big a deal. MLPs fully understand the barrier tax reporting represent to many potential investors. As a result, almost all MLPs now provide K-1s electronically and they are issued well before the April tax filing deadline. I’ve also yet to identify an accountant who will put a price on the additional cost of including a K-1 in a client’s tax return. Even at $100 each and a dozen K-1s, it’s well worth it for a portfolio of $500K or up invested in MLPs.

Not everybody has that much to invest, and others may nonetheless still prefer a simpler tax return consisting fully of 1099s for their tax reporting. Ten years ago I seeded Alerian Capital Management’s hedge fund when I was at JPMorgan. Much time and many expensive hours of tax advice were spent trying to come up with a way of maintaining the tax deferral benefits available to direct investors in combination with the simpler tax reporting of a 1099. The bottom line is, there is no way to do it. In this respect, the tax code is watertight. You can hold MLPs with K-1s, or you can invest through a vehicle that provides 1099s at the cost of a substantially greater tax burden.

For many years the industry didn’t spend much energy on the less efficient, 1099 route. But in recent years that has changed, as it turns out there is a ready pool of buyers who will sacrifice quite a lot for tax simplicity. In fact, the solution is a pretty blunt instrument in tax terms. Holding MLPs in a corporation (a “40 Act Fund”, which is a mutual fund or exchange traded fund), solves the tax problem by simply paying 35% tax on the returns. You can have MLPs with K1s, or 65% of MLPs with 1099s. Many people choose the latter, to the evident amazement of people in the industry. An example is the Mainstay Cushing MLP Premier Fund (CSHAX and CSHZX). I remember Jerry Swank, Cushing’s CEO, at a conference some years ago commenting with incredulity at the interest in a competitor’s exchange traded fund (ETF) which solved the tax reporting problem with the 35% haircut. But consumers know what they want, and Cushing subsequently provided it to them.

I wonder how many really know what they’re buying? CSHAX sports a yield of 6.34%, slightly above the yield on the Alerian Index of 6%. It invests in MLPs. But looks can be deceptive; CSHAX has underperformed the Lipper Energy MLP Fund for each year of its existence. Its expense ratio for 2013 (the most recent year available) was a whopping 9-10% (depending on the share class). Most of this (around 8%) is the “Deferred Income Tax” expense, which is the 35% Federal corporate income tax bite that the fund pays in order to provide those 1099s. 2013 was a great year for MLPs so the tax drag is unlikely to be that high every year. But it will nonetheless be an ever-present penalty, eating up a portion of results year after year. Due to a quirk in the way yields are reported, the 6.34% yield advertised by CSHAX is essentially what the fund pays BEFORE adjusting its NAV down to reflect the tax liability. The net, after tax result to the investor is inevitably lower, and that’s before they pay their own taxes.

Like many things that retail investors buy, it’s disclosed but probably not understood. ’40 Act companies that maintain MLPs at less than 25% of their holdings qualify for pass-through treatment, which means the deferral characteristics carry through to the investor. It’s the best you can do in terms of holding MLPs and avoiding K-1s. We run a mutual fund that offers this structure.

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.