If the arcane tax accounting of the mutual funds and ETFs that invest in Master Limited Partnerships (MLPs) is of no interest to you, let me save you some time and advise you to skip reading.

As the rest of you who have proceeded past the warning probably know, the attractive tax-deferred yields offered by MLPs require the investor to receive K-1s rather than 1099s at tax time. Many investors want to invest in MLPs without K-1s, and consequently funds were launched that provided a solution, of sorts. ’40 Act funds can hold MLPs on behalf of their investors and provide 1099s, but they may have to pay corporate tax on the returns. If the fund is RIC-compliant, in that it owns less than 25% publicly traded partnerships (i.e. MLPs), investors get pass-through tax status. However, if the fund is not RIC-compliant it is structured as a C-corp and subject to corporate taxes. So the result is that the investors in non-RIC compliant funds only receive 65% of the return (i.e. 1 minus the 35% corporate tax rate). The Mainstay Cushing Fund (CSHAX) is an example, but there are others. Unfortunately, $52BN of the $64BN invested in MLP investments via ’40 Act funds are structured as C-corps (Source: Alerian). Ron Rowland wrote about this issue as long ago as 2010.

The tax drag shows up as part of the expense ratio, so CSHAX sports an eye-popping 9.42% expense for the year through 2/27/15, of which 7.49%-7.94% is taxes. Other funds are similar. Remarkably, few investors are aware of the tax drag in the MLP investment funds they own. Not surprisingly, it’s hard to get anywhere close to the benchmark Alerian Index under such circumstances, since such funds solve the K-1 problem by throwing substantial amounts of their investors’ money at it — or more accurately, to the U.S. Treasury.

There is an odd sort of silver lining to this tax drag though; it works in both directions. Just as the fund delivers 65% of the upside, it also delivers 65% of the downside. As MLP investors are painfully aware, prices have been in retreat since last August, and in recent weeks retreat has become rout. Since the tax bill comes from unrealized gains, a reduction in those gains through a drop in market prices reduces the future tax bite commensurately. It results in lower volatility, which is normally a desirable quality for investors although in this case of dubious value; volatility could be further reduced if the corporate tax rate was increased beyond 35%, which is clearly not the type of risk management investors want.

There is an interesting and so far unanswered dilemma that can face such a taxable MLP investment product during an extended market turndown (perhaps such as the one we’re enduring). Just as the Deferred Tax Liability for unrealized gains can fluctuate with market moves, it can in theory become a Deferred Tax Asset (DTA). This can come about when the non-RIC compliant investment fund holds investments that are at a mark-to-market loss, such that rather than creating a future tax burden they represent something similar to a tax-loss carryforward, or a net operating loss. CSHAX among others seems to contemplate holding a DTA where market moves create one, according to its prospectus. This has the effect of increasing the fund’s NAV above what it would be simply based on the securities it holds. However, the accounting can quickly get tricky if investors begin to exit the fund. This is because an exiting C-corp ’40 Act investor that receives an NAV on their shares subsidized by the DTA leaves behind a fund that is now slightly smaller but has the same DTA, meaning the DTA represents a larger share of the remaining investors’ NAV. Continuing redemptions could propel this process to where benefiting from the DTA was no longer plausible, at which point the DTA could be subject to a “valuation allowance” (the language in the CSHAX prospectus). At that point, the fund might be in the unenviable position of providing investors still only 65% of the market upside combined with 100% of the downside, a set of circumstances likely to induce further redemptions, exacerbating the situation. As the funds themselves point out, the appropriate tax treatment is not clear. It’s an untested area.

This is theoretical. We haven’t actually seen this play out yet, but it’s a useful scenario to consider for such investors.

What should you do? If you own an MLP mutual fund or ETF, look carefully at the expense ratio. Funds set up as C-corps (i.e. not RIC-compliant) are an expensive way to access the asset class, and are unlikely to offer satisfactory returns. The best course is to sell and consider replacing with a RIC-compliant fund. At least the harm of the original investment error has been mitigated by the recent sell-off, since the tax treatment has cushioned the losses you’ve incurred. And if the Deferred Tax Liability of your MLP investment fund is heading in the direction of becoming a Deferred Tax Asset, with its uncertain ultimate realization to the fund, consider a more speedy exit.

How ironic that investors seeking to avoid the tax complexity of K-1s are nonetheless facing tax complexity of a different sort.

We also run a RIC-compliant mutual fund, and you can learn more about it here.

Nothing in this blog should be construed as offering tax advice.  Investors should seek their own tax adviser or tax attorney.  This document is not an offer to purchase or sell, nor a solicitation of an offer to purchase or sell an interest in a Fund.

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.