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This essay will explain why they might want to do that—and how you can get income from MLPs without paying corporate tax.

Energy MLPs, which account for the bulk of the MLP sector, handle hydrocarbons, using pipelines, storage tanks, fractionation plants or railcars. Enterprise Products Partners (EPD), a classic of the genre, owns all those things.

MLPs are boring but they pay fat dividends. EPD’s yield is 6.7%. Buckeye Partners (BPL) hands out 11.4%; Magellan Midstream Partners, 5.8%. Sheltered by pipeline depreciation, dividends tend to be tax-free in the early years of an investment. A fund containing many MLPs would be a terrific way to get diversification combined with a nice income stream.

Except for a little problem. A peculiarity of the tax code is that a fund’s tax exemption is snatched away if the fund puts more than 25% of its assets in partnerships. So if you want your fund to be a pure play on MLPs, the fund must lose a chunk of your profits to taxes. That’s why the Alerian fund’s average annual return since it opened its doors in August 2010 has been only 1.7%, while the MLP index it follows has delivered 4.2%.

The simple way for an energy fund to duck the corporate tax is to broaden its portfolio. It can blend a 25% allocation to MLPs with a 75% allocation to other energy companies, taking advantage of the fact that many pipeliners, like Targa Resources, Oneok and Williams, are organized as corporations rather than partnerships.

But the tax-light funds are outsold by the taxable ones. Why is that? Is it that investors want a concentrated dose of high-octane MLPs and won’t tolerate the blending fuels? Is it perhaps that they don’t understand the weird accounting? Read the explanation of the tax expense in Alerian’s financials and you will be ready to check yourself into an insane asylum.

Whatever the reason, the fact that Alerian and other taxable MLP funds are big sellers is a source of unending frustration to Simon Lack of SL Advisors, a manager of energy portfolios. Lack runs two 25/75 funds that have, between them, a mere $157 million of assets. “People are invested in AMLP even though their performance is only 50% of the index return,” Lack complains.

Jeremy Held, director of research at Alps, the firm that operates the Alerian fund, insists that his fund’s buyers know what they’re doing. They want diversified exposure to the MLP sector and they don’t want to tangle with the pile of K-1 tax forms they’d get if they owned partnerships directly. Held says that it’s not just small investors who opt for the fund. He has seen buyers with seven-figure stakes.

Like Lack’s 25/75 funds, the Alerian MLP ETF gives investors a 1099 dividend report instead of a K-1. That cuts their tax preparation bills, and it also enables them to put energy infrastructure in a tax-deferred account like an IRA. (Direct ownership of partnerships in an IRA creates chaos.)

How much do you sacrifice when you use a fund organized like the Alerian ETF?

To illustrate, we’ll start with a hypothetical MLP trading at $10 a share and paying a $1 annual dividend. Depreciation, we’ll assume, is more than enough to shelter the dividend (this is typical), so that the entire payout is considered a “return of capital,” not immediately taxable.

If you own the share directly you pocket the $1 without owing any tax for now. Your $10 cost gets adjusted down to $9. That will boost your taxable gain when you do sell. But if you have your wits you never sell.

Now suppose the share is held in a taxable MLP fund. For simplicity we will assume that the fund has no management fee.

The fund, too, will enjoy $1 of income not immediately taxable. But it must allow for the possibility that the MLP share will be sold tomorrow. If the fund did have to sell the MLP to meet redemption orders, it would owe corporate income tax on a $1 gain. The federal tax rate is 21%; state taxes add another 2 points or so. That means the fund has to set aside 23 cents for future corporate tax.

The fund may choose to disburse the entire $1 of income to fund shareholders (again, typical), in which case the fund’s books will show an asset of $10 (the MLP share) and a liability of 23 cents (potential income tax). The fund’s reported net asset value will be $9.77. Someone holding the fund will see, on his brokerage statement, a 7.7% return; had he held the MLP directly he would have seen a 10% return.

What if the MLP share appreciates? Let’s assume no dividend, simply a bull market that sends the MLP up 10% to $11. Again, a fund that pays corporate tax has to allow for 23 cents of deferred tax liability. If the fund did sell its MLP it would owe income tax on the $1 gain, and at the usual corporate rate, since corporations get no break on long-term capital gains.

Allowing for the potential future tax, the fund holding the appreciated MLP will report an NAV of $10.77, for a total return of 7.7%. The buy-and-hold direct buyer of the MLP share would be up 10%.

MLP funds

Here you see the gap between index returns and fund returns that Simon Lack is complaining about. (Note: For 2018 and later years the gap will be smaller because of the Trump tax cut.) The gap is at first only on paper; the diminished NAV doesn’t damage the $1 of income coming from the MLP. But on eventual liquidation those years of corporate tax will be felt in a shriveled sale price for the fund.

What if there’s a bear market? Since the tax-burdened fund delivers only 77% of the return going up, can it limit your damage to 77% on the way down? That depends on the sequence of events.

If the MLP share goes from $10 to $11 and then back to $10 the fund investor will be cushioned on the way down, as the NAV falls only 77 cents, from $10.77 to its starting point. In general, funds that have delivered years of positive returns wind up with a deferred tax liability, and if losses then ensue those losses will be cushioned as the tax liability shrinks.

But funds that have piled up losses are usually left with no cushion against further declines. Picture a fund whose assets sink from a starting value of $10 a share to $9. That fund has a deferred tax asset worth, in some theoretical sense, 23 cents a share, because it’s in a position to earn $1 a share without owing tax on that gain. But it would be very hazardous for the fund to report its net asset value as $9.23. Departing fund investors could walk out the door with $9.23 of cash, leaving behind meager hard assets and a pile of tax loss carryforwards that never get used.

In such a fix most funds display a deferred tax asset of 23 cents and then, in the very next line, erase it with a “valuation allowance” of minus 23 cents. The tax situation is visible but doesn’t alter the NAV, which will be just the $9 value of the portfolio.

Funds with deferred tax assets that are duly erased should be appealing to a bullish investor. You don’t pay anything for the tax shield and so you can enjoy, at least for a while, 100% of the return on the portfolio. You are also exposed to 100% of the losses. Once the fund climbs into the black (in cumulative total return), it starts showing a deferred tax liability and you start getting 77% of the upside and 77% of the down.

So far we have described what happens to investors who hang on indefinitely. What happens to investors who sell?

Take the case of an MLP that climbs from $10 to $15 over a period of years while paying a cumulative $6 in return-of-capital dividends. On sale, the direct holder will have a $5 long-term gain plus something like $6 in what I call boomerang income. (The concept is explained in 2018 Tax Guide to MLPs.)

Including Obamacare at 3.8%, the maximum federal tax on the long gain will be $1.19. The boomerang is taxed at ordinary-income rates but benefits from the recently enacted 20% deduction on pass-through business income; Obama arrives again, with no mercy from the new deduction. Maximum boomerang tax = $6 x (0.038 + 0.8 x 0.37) = $2. Net realization from the sale: $11.81.

Now put the MLP inside a taxable fund. The fund will be accruing corporate tax liability all along. Since corporations don’t get the 20% pass-through deduction the ending NAV will be $15 – 0.23 x $11 = $12.47. The investor will have a cost basis of $4 ($10 purchase price of the fund, minus dividends). Tax on the $8.47 of long gain would be $2.02, for a net realization of $10.45.

Advantage: direct ownership.

As noted, you’d be a fool to sell an MLP, unless, perhaps, it’s such a disaster that the capital loss deduction is worth more than what the boomerang will cost you. Moreover, the advantage of holding directly grows over time. Bear in mind that unrealized appreciation (on either MLPs or MLP funds) becomes tax-free on your death, and so does boomerang income.

The accounting laid out so far in this story assumes high depreciation deductions. That pretty well describes the world we are living in. But the day will come when those write-offs peter out. What would happen if the entire $1 distribution from an MLP were taxed as ordinary business income?

The taxable fund would have 77 cents left, which would come to you as a qualified dividend. After maximum federal taxes you’d have 59 cents to spend on yacht fuel. If you owned the MLP directly you’d benefit from the pass-through deduction and would owe 33 cents, for a net of 67 cents.

There would be a transition period between the point when most of the profits in the system are a return of capital to the point where most are ordinary business income. During that transition the corporate-taxed fund would have one advantage, says Robert Velotta, an MLP expert at Cohen & Co. in Cleveland: the ability to marry an operating loss from one MLP to the operating income from another. Direct holders have to keep their MLPs, and their loss carryforwards, in separate silos.

But as a direct holder you have something else going for you. Once you’ve recovered your purchase price in cumulative dividends, further dividends can give rise to a blessed pairing of ordinary deductions (suspended losses from earlier years, now usable against salaries and interest) with capital gains (taxed at low rates, or, if you have a loss carryforward from your General Electric shares, not taxed). Explanation. With a fund in the middle you can’t do that.

In tax burdens the 25/75 funds fall midway between direct ownership and ownership via an Alerian-style fund. They don’t pay corporate tax. They can pass through return-of-capital money, but they can’t pass through losses.

Add it up. For investors who are equipped to deal with K-1s, the tax laws powerfully favor direct ownership.


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Buy 600 AMZA at $7.61. At the current purchase price and assuming the continued monthly dividend of $0.11/share, that is a 17.4% yield [subject to taxes, see next article]. I like the monthly payout of $66.00/share on the position. It fits nicely with my strategy for this position.

An added bonus is the ability to use Options. To be fair, the market currently is really shallow and illiquid. I’m hoping that will change. Currently I have 2 orders in, but I’m not overly optimistic of getting a fill.

This is for a longer term position.

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MLP Interest Rates: As yield-based investments, MLPs carry interest rate risk and may underperform in rising interest rate environments. Additionally, when investors have heightened fears about the economy, the risk spread between MLPs and competing investment options can widen, which may have an adverse effect on the stock price of MLPs. Rising interest rates may increase the potential cost of MLPs financing projects or cost of operations, and may affect the demand for MLP investments, either of which may result in lower performance by or distributions from the Fund’s MLP investments.

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Made the trade. Just swapped IBB for an equal position in XBI. In the process closed the IBB April, and opened an XBI May.

This was done for the reason that XBI trades at circa $55 and IBB at circa $260. XBI is also a SPDR product, not that it makes much practical difference.

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IBB is my long-term core position that I trade around. I collect circa 1% return/month on this core position, irrespective of capital fluctuations.

IBB had a bit of a move higher this week. There is a bit of chatter that this might be the end of the down trend and the start of a move higher, but, who knows.

XIB which is another biotech ETF actually has a higher dividend and a lower priced unit. I’m tempted to flippe-floppe into XIB as it suits my trading style better than a high priced stock, so tomorrow I may swap, even though I’ll incur brokerage charges all around.


Swapping these positions one for t’other




I had two big winners off of earnings today:



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