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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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The Chicago Tribune recently wrote about how the decision to reduce the expected-return assumption from 7.5% to 7.0% for the Illinois Teachers Retirement System resulted in the governor calling for approximately $400 million in additional taxes.

While the political positioning behind this small move of 0.5 percentage point is fascinating, it more importantly brings to the forefront the issue of how large future obligations are, and why there is a lot of fear and an incentive to hide.

If reducing the expected return assumption from 7.5% to 7.0% results in an additional $400 million- 500 million a year of taxes, then moving the liability discount rate to something closer to a risk-free rate of 3% may imply additional $5 billion in additional contributions (Note: the actual number is likely several times higher than this – see the illustration below for some simplified math).

The dilemma we face is that we have made future promises and don’t have enough money set aside today to pay them. Therefore someone has to make up the shortfall. Instead of trying to determine who makes up the shortfall, we try to bury our heads in the actuarial sand of high expected returns.
But where can Illinois get the additional $5 billion a year? And where can America get the additional $6 trillion?

Investment returns aren’t going to help:

The Teachers Retirement System assumes that investment returns over the long-term will average 7%. With liabilities of $108 billion, and assets of $41 billion, even if investments return 7% per annum, the hole will only continue to grow (see Illustration below). This is why using investment-return expectations to discount liabilities isn’t appropriate.
But investments don’t return 7% year-in, year-out. For simplicity, let’s assume the long-term horizon to be 10 years. Even if there is one year where returns are negative-20%, this results in an asset value that is over $20 billion lower (see illustration below).
When risk-free rates were around 6%-7%, generating 8%-10% expected returns required minimal risk and complexity. However, with risk-free rates at 2%-3%, generating even 7% is a lot harder. While investment teams at pension funds such as Teachers are extremely capable, high expected returns are forcing them to take on additional risk, either in the form of increased leverage or complex investments.

The Rockefeller Institute of Government points out that “taxpayers and citizens may or not want this risk taken on their behalf, but they have little say in the matter. And they have no easy way out: If they want pension funds to take less risk, they’ll have to increase government contributions by even more than contributions have gone up already”.

Inflation may not help either.

Arguments in favor of using higher discount rates tend to revolve around the “artificially low” level of interest rates fueled by central-bank actions, and a belief that discount rates would return to a more “normal” level in the future. However, a return to “normal” is likely to be accompanied by an increase in inflation. For public plans, higher inflation could actually be a problem, as benefits tend to be linked to inflation, and therefore liabilities would likely get larger, not smaller, with inflation.

Therefore, by not putting in the money today, we are effectively making a leveraged bet on the stock market, and hoping it pays off, and praying that inflation stays low.

If average returns are only 6%, state funds in aggregate will run out in 2024. That’s only eight years from now.
And if the bet doesn’t work then who will pick up the pieces?

In 2010, Stanford Prof. Josh Rauh estimated that if state pension funds earned an average return of 8% on their assets, then states would in aggregate run out of funds in 2028. If average returns are only 6%, then state funds in aggregate will run out in 2024. That’s only eight years from now.

According to Rauh, funds would need to earn at least 10% per annum out to 2045 in order to sufficiently meet their obligations.

Higher inflation and lower investment returns would only make this situation worse. Current taxpayers and lawmakers are either unwilling or unable to shoulder the burden, as recent events in Illinois have highlighted.

This then shifts the burden to future taxpayers. As this burden becomes more apparent, Rauh speculates that taxpayers may choose to relocate from states with high unfunded pension liabilities. This would, in his opinion, increase the likelihood of a federal taxpayer bailout. Failing that, states would have to resort to what has so far been unthinkable — cutting benefits. In the absence of a federal bailout or a cut in benefits, it’s likely that municipal-bond holders would have to take a hit, as tax dollars get used to fund pension benefits.

Quantifying the true extent of liabilities is the first step in recognizing the magnitude of the problem; the amounts involved are too large to ignore, and it impacts almost everyone. Hopefully policy makers can make informed decisions before its too late.

If decisions aren’t made, then our only hope is that we earn over 10% investment returns each year. Would you take that bet with your future?

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The revelations about offshore accounts that came to light in the so-called Panama Papers will reinvigorate government efforts to rein in not just tax evasion, which is illegal, but tax avoidance, too.

They will also add to popular frustration that will challenge the authority of some government officials. The uproar will bring about enhanced enforcement measures. Yet there also will be unintended consequences that will further erode the credibility and effectiveness of the political establishment, including its ability to govern from the center, which is already being tested.

In the wake of the global financial crisis, and given the alarming surge in wealth inequality, the governed will prove far less accepting of the legal distinction between tax evasion and tax avoidance. Both are now viewed not just as “tax dodges,” but also as the unfair perks of the better-off and more-connected members of society in many countries.

Enter last week’s “Panama Papers,” the trove of more than 11 million pages of documents from Mossack Fonseca, a Panama-based law firm. The documents suggest that in both advanced and developing countries, some of those who hold power, and those with access to them along with the “rich and famous,” used the firm to establish and manage offshore entities that are designed to protect capital and minimize taxation.

The political repercussions were immediate, and are likely to spread. Already, the scandal has led to the resignation of Iceland’s prime minister, to a political outcry that has required U.K. Prime Minister David Cameron to release his tax returns (a first for Britain’s top elected official), and has abruptly ended the political honeymoon of Argentina’s new president, Mauricio Macri.

 

In addition, countries including Germany are stepping up efforts to look into curbs on legal, but morally questionable tax avoidance schemes that benefit the wealthiest. As with earlier steps to limit money laundering, the focus will be on more stringent reporting requirements, better international sharing of data, and more closely coordinated cross-border verification and enforcement efforts.

These changes will be quite visible; and will have a meaningful impact for those who, until now, have found it easy to use offshore financial vehicles to reduce their tax payments. The measures’ effects on politics and governance, while they will be less visible, could be more consequential for broader segments of society.

The Panama papers are yet another blow to the political establishment. They amplify popular resentment toward governments that already are perceived by a significant segment of the population as turning a blind eye to tax-dodging. That anger is stoked by disclosures that some high-ranking officials also availed themselves of the shelters. And though no laws were broken in most cases, the documents will feed the perception that the privileged are allowed to play by different rules.

Indeed, for many, the Panama Papers are reminiscent of a broader phenomenon that played out in the run-up and the aftermath of the 2008 global financial crisis: The perception of a system run and managed by a political establishment that serves the rich and connected and fails to hold these elites accountable for the damage they cause to the rest of society. There is still notable residual resentment that very few bankers were brought to justice for their role in a financial debacle that caused significant misery and almost tipped the world into a devastating multiyear depression.

By stoking residual anger and fueling anti-establishment movements, the Panama Papers will make it even harder for the established parties to come together and implement policies aimed at overcoming years of sluggish economic growth, worsening inequality and artificial financial stability.

In addition, two other developments last week also eroded the credibility of the political establishment: the failure of the Dutch government to convince citizens to back a trade and cooperation agreement between the European Union and Ukraine, and the turnaround of a growing number of members of the Republican establishment (including Lindsey Graham, Mitt Romney and Scott Walker) who lined up behind Ted Cruz as their preferred candidate.

There will be even less appetite to govern from the bipartisan political center, thus making it more difficult to secure sufficient buy-in for pro-growth structural reforms, better demand management and more timely solutions for excessively high levels of over-indebtedness.

There’s no doubt that the Panama Papers will produce greater efforts to reduce tax minimization (whether through legal avoidance or illegal evasion). That is good news for liberal democratic systems that rely on a rule of law that is viewed as fair and credible. But in the short-term this will be accompanied by even stronger resistance to the kind of political unity that is needed in several countries to deliver high growth and genuine financial stability.

 

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The fundamental relation of capital to income has been much discussed by economists, the former being likened to a tree on the land, the latter to the fruit or the crop; the former depicted as a reservoir supplied from springs, the latter as an outlet or stream to be measured by its flow during a period of time…Here we have the essential matter; not a gain accruing to capital; not a growth or increment of value to the investment: but a gain, a profit, something of exchangeable value proceeding from property, severed from capital.

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Income concepts can be viewed as a pyramid. As one moves from the broad notion of psychic income through the foundation and accounting concepts of income to the legal concept, the interpretation of income continually narrows. More and more items are excluded from income as one progresses from one discipline to the next and in doing so one moves further away from the ‘ideal’ taxation target. Taxation is based on the legal concept of income – the concept farthest removed from the ‘ideal’ on the income pyramid.

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Federal Revenues

The economy growing slowly as measured by tax receipts.

The cliff.

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