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.
Key Takeaways
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 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.
Special Considerations
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.
Exchange-traded notes (ETNs) are types of unsecured debt securities that track an underlying index of securities and trade on a major exchange like a stock. ETNs are similar to bonds but do not have interest payments. Instead, the prices of ETNs fluctuate like stocks.
tend to track the underlying index better than MLP ETFs because the MLP ETF is structured as a C-corp
C-corp
What Is a C Corporation? A C corporation (or C corp) is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. C corporations, the most prevalent of corporations, are also subject to corporate income taxation.
ETNs are structured products that are issued as senior debt notes, while ETFs represent a stake in an underlying commodity. ETNs are more like bonds in that they are unsecured. ETFs provide investments into a fund that holds the assets it tracks, like stocks, bonds, or gold.
Both exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are securities that track an index. An ETF outright owns the underlying securities of the index while an ETN is like a bond; it is an unsecured debt note issued by a financial institution that pays out the return over the index over a period of time.
The largest MLPs ETF is the Alerian MLP ETF AMLP with $8.32B in assets. In the last trailing year, the best-performing MLPs ETF was MLPR at 44.39%. The most recent ETF launched in the MLPs space was the Global X MLP & Energy Infrastructure Covered Call ETF MLPD on 05/08/24.
ETNs don't distribute dividend or interest income the way a stock or bond fund may, so most taxes are deferred and taxed as capital gains. However, ETNs based on foreign currencies are an exception. The gains on these ETNs are taxed as ordinary income.
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.
One major risk that comes with ETNs is credit risk: If the issuing institution defaults, your principal and return go with it. Short of that, even bad news about the issuer could ding the price of its ETN, impacting you if you wanted to sell it before maturity.
Disadvantages of ETFs. Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ETFs are traded on the stock exchange like an individual stock, which means that investors may have to pay a real or virtual broker in order to facilitate the trade.
So why would anyone own an ETN? With an ETN, an investor might get a better deal on taxes, particularly in commodities. If you have a futures-based position, it's marked-to-market, and you are going to get a K-1—something many investors don't want. ETNs don't distribute K-1s.
Investors could find it difficult to cash in certain ETNs with low liquidity. Volatility risk: Since ETNs do not pay dividends, the only way to make a return on your investment is if the underlying asset is worth more at maturity (or when you sell your ETN) than it was at the time of purchase.
Master limited partnerships (MLPs) are known for their potential to provide tax-advantaged income. But they have also generated attractive total returns in recent years. Despite positive fundamentals driven by solid free cash flow generation, MLPs may be overlooked by investors given so many income investment options.
MLPs tend to generate higher yields than bonds and stocks due in part to the favorable tax structure. Most MLPs are listed on national exchanges and are therefore typically more liquid than traditional partnerships.
In an MLP, instead of paying a corporate income tax, the tax liability of the entity is passed on to its unitholders. Once a year, each investor receives a K-1 statement (similar to a 1099-DIV form) detailing his or her share of the partnership's net income, which is then taxed at the investor's individual tax rate.
The ETF is taxed as a regular corporation and is subject to US federal income tax on taxable income at the corporate tax rate (currently as high as 21%) as well as state and local taxes. The Fund is classified for federal income tax purposes as a taxable regular corporation or so-called Subchapter “C” corporation.
Both ETFs and ETNs are designed to mirror the investments tracked by an index or other benchmark. When you invest in an ETF, you are investing in a fund that buys and holds shares of the assets in the benchmark it tracks. An ETN is more like a bond. It's an unsecured debt note issued by an institution.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
Recall that investing in an ETN means loaning money to a financial institution that promises to pay it back based on the performance of the index. Consequently, the return will be directly pegged to the value of the index. But that also means your investment is vulnerable to the credit risk of the issuer.
With a mutual fund, you buy and sell based on dollars, not market price or shares. And you can specify any dollar amount you want—down to the penny or as a nice round figure, like $3,000. With an ETF, you buy and sell based on market price—and you can only trade full shares.
ETCs are debt instruments and the commodities tracked by the ETC serve as collateral for the debt note. They allow investors to gain exposure to a single security such as gold. ETFs, on the other hand, need a minimum level of diversification under UCITS regulations and cannot hold physical commodities.
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