Yield-seeking investors are piling into master limited partnerships, but adding these energy infrastructure investments to a portfolio can add tax complications.
The Eagle MLP Strategy Fund (EGLAX) strives to ease the process for the average person in this niche field by avoiding the complicated tax filings involved in these types of partnerships.
MLPs have features of limited partnerships, but trade like a stock. Many are focused in the energy sector because MLPs must receive 90 percent of their income from “qualifying” activities that are generally focused on natural resources, including energy.
Many energy-focused MLPs are engaged in managing pipelines and/or storing oil and gas. These businesses create steady income, but also have big infrastructure investments that need to be depreciated over a long time.
Income is distributed as a return of capital, so MLPs avoid federal and state corporate income tax. However, MLP owners are required to pay income tax in each state the MLP does business via a Schedule K-1 form, and owners face rules regarding unrelated business taxable income.
To make MLPs easier for retail investors, the providers of closed-end funds, exchange-traded products and mutual funds have created offerings that hold shares (known as units in MLPs) in multiple MLPs to offer both diversity in a pooled fund and to issue only 1099 dividend forms at tax time.
In the process, many have stripped away one of the benefits of MLPs––tax efficiency. If a regulated investment companies (RIC) wants to keep their tax pass-through status, their holdings in securities that issue a Schedule K-1 form are capped at 25 percent. The rest could be in other energy securities, which makes these RICs more like an MLP-focused investment than purely an MLP fund.
If the fund invests more than 25 percent in companies that issue Schedule K-1 forms, they lose the pass-through tax status and the fund is structured as a C corporation. Many of these opt to invest 100 percent in MLPs. However, C corporations are taxed on the income they receive from the investments, and they pass on the reduced income to investors, who then pay their own taxes, so the same income stream is taxed twice.
Fly Like An Eagle
The Eagle MLP Strategy Fund sought to keep the tax advantage of a RIC, but to include other investments in energy infrastructure. The fund retains the complete tax pass-through by limiting its investments in Schedule K-1 issuing firms to 25 percent of its holdings.
The other 75 percent is invested in general partnerships, shipping MLPs, MLP-tracking stocks and exchange-traded notes––all entities that issue 1099s. This allows Eagle to keep the pass-through status at the fund level and is the source of their tax efficiency, says David Chiaro, managing director at Houston-based Eagle Global Advisors.