What's the difference between an MLP exchange-traded fund (ETF) and an MLP exchange-traded note (ETN)?

The main difference between a master limited partnership (MLP) exchange-traded fund (ETF) and an MLP exchange-traded note (ETN) is the tax consequences for distributions from each asset. Both MLP ETFs and ETNs track an underlying MLP index.

MLP ETFs are often structured as C-corporations. These corporations pay corporate income tax on distributions before they are passed on to investors, 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, 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.

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 they are 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, the 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.

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 utilized correctly and is not available to those who own the MLP stock directly instead of in an ETF or ETN.

Both the ETF and ETN allow investors to avoid having to file a K-1 tax form, which is an advantage. A K-1 is required for distributions received from the outright ownership of an MLP, which can complicate tax filings for many investors. 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. If MLP units are held directly in an IRA, the IRS has defined distributions from the MLPs as unrelated business taxable income that must be paid in the year it is realized. 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.