A master limited partnership (MLP) is a specific type of limited partnership that is publicly traded. Under this legal structure, limited partners are the investors who provide the capital to the MLP in return for income distributions from the MLP’s cash flow. The general partner can be considered the fund manager and is responsible for the management of the fund, a task for which he receives compensation.
An MLP is a unique investment opportunity in that it combines the tax savings of a limited partnership and the liquidity of a stock. MLPs are also unique because they need to derive 90% or more of their income from activities related to real estate, commodity or natural resources.
Combining the concept of an MLP with that of an exchange-traded fund (ETF), MLP ETFs are market-traded assets that mitigate the excess paperwork associated with being a limited partner. MLP ETFs also mitigate risk through diversification. Each MLP ETF is essentially an ETF that invests in a specific group of MLPs — some focus on real estate, and others focus on oil pipelines or infrastructure MLPs.
An MLP ETF is a unique structure that’s designed to deliver good income to its investors without the hassle that comes from being a limited partner of the fund itself. As a part of the complex structure, the ETFs themselves are often considered C-corporations and are subject to income taxes that the MLPs themselves are not.
For comparison, most ETFs are structured as regulated investment companies and are not subject to the same tax liabilities that C-corporations are. The reason for the different structures goes back to restrictions on limited partnership ownership.
Under government regulations, a normally structured ETF is not allowed to have more than 25% of the funds’ assets in limited partnership interests. Of course, an MLP ETF would essentially be 100% invested as a limited partner to the various MLPs the fund holds.
C-corporations do not have these same restrictions and were, thus, chosen as the legal structures for these unique ETFs. The trade-off for being 100% invested in limited partnership interests was to accept a higher tax liability. Since an MLP ETF is structured as a company, the income it receives from its investments is taxed before it is given to the fund’s shareholders.
The standard tax rate for corporations in the United States is 35%, and this rate is applied to MLP ETFs, which increases the fund’s expense ratio beyond the standard fees charged by the fund manager.
Once the ETF pays out dividends to its shareholders, they will also be individually liable for the income taxes on the revenue, which indirectly increases the overall cost to investors.
In this way, it can be seen that the combination of an MLP and ETF offers the diversity of an ETF with the income of an MLP, but the legal structure necessary to make an MLP ETF viable creates tax liabilities to the fund and investor that makes it an expensive investment.