Over the past several years, there has been a significant increase in the number of Master Limited Partnerships (MLPs), the market capitalization of MLPs, and the number and type of investment products being offered to allow investors exposure to MLP investments. The purpose of this article is to provide a basic understanding of the unique characteristics of MLP equity funds and how they differ from other non-MLP focused funds.
Structure of the Fund – RIC or C Corporation
Most 1940 Act funds are structured as Regulated Investment Companies (RICs). The primary advantage of a RIC is that a RIC may deduct dividends paid to investors in calculating the taxable income at the fund level. This treatment essentially allows the RIC to avoid a corporate level tax. Shareholders of a C corporation, however, face a double layer of taxation – income is taxed at the corporate level on income when it is earned and then the investors are taxed at the shareholder level when dividends are paid by the corporation.
Prior to 2004, RICs had a difficult time investing in MLPs due to concerns about whether the income from the MLPs would be considered qualified income for the RIC. The American Jobs Creation Act of 2004 amended the RIC qualifying income rules to include net income from qualified publicly traded partnerships. However, this Act also placed limitations which restrict RICs from having more than 25% of the RIC’s assets in qualified publicly traded partnerships due to Congressional concern about using the potential for tax-exempt investors or foreign investors to use the RIC structure to avoid unrelated business income tax or withholding taxes that may apply if these investors had direct holdings in the partnerships.
Because of the 25% limitation for RICs, a 100% MLP fund will not qualify for RIC status and would be taxable as a C corporation. However, there have been several energy and infrastructure focused funds that have launched over the past few years which have limited their MLP exposure to 25% of the Fund in order to qualify for RIC status. These funds often invest the remaining 75% in corporate investments in MLP general partners or other energy/infrastructure focused companies that are structured as corporations. Many people view these RIC structures as a more tax efficient investment as compared to the RIC, however the comparison is really that of apples and oranges, they are fundamentally different investments. In order to avoid the corporate level tax at the fund level, a RIC must have at least 75% of its assets invested in corporate investments, which pay tax at that level which would theoretically reduce distributable cash flow available at the investee company level. In addition, and as discussed later in the article, dividends paid from an MLP C corporation fund may qualify for preferred tax rates to investors as a qualified dividend without regard to the income earned by the corporation. In contrast, RIC MLP funds may only classify dividends paid to investors as qualified dividends to the extent of the qualified dividend income earned by the fund.
Taxation of Income from Investments
Investments in partnerships have fundamentally different taxation than investments made into C corporations. For an equity investment made into C corporations, as most publicly traded companies are structured, distributions paid by the investee corporation to the investor are generally taxed as dividend income. The amount paid to purchase the shares of the corporation is generally the investor’s tax basis in the investment for determining the amount of gain or loss on the disposition of stock.
In contrast, distributions paid by a partnership are not taxed as dividends and are instead taxed as a return of capital to the extent of the fund’s basis in the partnership. However, the fund investing in a partnership must report the various items of income, deductions, gains, and losses reported on the partnership’s Schedule K-1 in computing the fund’s taxable income. The investor’s tax basis in its investment in the partnership starts with the purchase price on acquisition but also must be adjusted to consider the taxable income, return of capital distributions, and other items to appropriately calculate the investor’s basis in the partnership investment.
Calculating Tax Liabilities – a C Corporation Problem
Under Accounting Standards Codification Section 740 (ASC 740 and previously FAS 109), a corporation must account for income taxes on an accrual basis. This accounting must include current taxes that the corporation expects to pay within one year (i.e. a current payable) and deferred taxes (i.e. and asset or liability that will increase or decrease any subsequent period’s amount of tax to be paid). Any tax liability, either current or deferred, results in an expense for the corporation and a corresponding reduction of equity at the time the expense is accrued. For a traditional corporation, like a manufacturing or retail corporation, these tax liabilities have an indirect impact on a shareholder’s value in the corporation. In addition, these calculations often occur after pre-tax financial statement income is calculated for a reporting cycle (i.e. quarterly, annually).
MLP C corporation funds differ in this regard. Net Asset Value (“NAV”) is critical to these funds. NAV impacts the price by which investors subscribe and redeem daily in an open end fund and impact the discounts and premiums for Closed End Funds and Exchange Traded Funds. Funds need to have policies in place to effectively and efficiently calculate tax liabilities in an MLP C corporation fund on a daily basis in order to properly compute a NAV.
These policies and procedures should not only consider the impact of Federal taxes, but also the impact of addressing the unique tax laws of all 50 states in the US. As underlying MLPs operate in various states, and some in foreign countries, funds may have exposure to income and/or franchise tax in these states. Monitoring changes in laws, tax rates, and business activities of the MLPs in these states can be a daunting task, but failing to appropriately address these items can have a material impact on a fund’s NAV.
Taxation of Distributions to Shareholders
Another unique character of MLP funds is the taxability of distributions made to investors. In order to meet RIC qualification requirements, an MLP fund taxed as a RIC must distribute at least 90% of its taxable income to shareholders on an annual basis. MLP C corporation funds do not have this requirement to distribute, so an MLP C corporation fund has no tax requirement to make any distributions to its shareholders. Practically speaking, however, most MLP C corporation funds have decided to make regular monthly or quarterly distributions in order to provide the cash flow to investors in a manner similar to what they would receive in a direct investment in an MLP.
The taxability of these distributions made by these MLP funds can create confusion to investors. Specifically, there may be many cases where some or all of the distributions paid by the MLP fund to investors may be classified as a return of capital, and not taxable as a dividend to investors. This classification is dependent on the earnings and profits (E&P) of the fund.
Distributions from any fund (RIC or C corporation) is only taxable to the extent of the fund’s current or accumulated E&P as described under IRC Section 312. Effectively, E&P starts with taxable income and requires adjustments to calculate E&P. For MLP funds, one of the most notable adjustments relates to different rules required for calculating depreciation expense for tax and E&P purposes on assets acquired by the underlying MLPs. These E&P adjustments may have a significant impact on how much of the distributions paid by MLP fund to its investors may be considered a taxable dividend vs. a return of capital.
Whether a dividend from an MLP fund would qualify for the preferential tax rates associated with a qualified dividend may differ based upon the MLP fund’s structure as a RIC or as a C corporation. Dividends from MLP C corporation funds would meet the requirements for these reduced qualified dividend rates if an investor receiving the dividend owns the stock for more than 60 days during the 121 day period that begins 60 days before the ex-dividend date. Dividends from MLP RIC funds, however, may only qualify for these reduced rates to the extent the RIC receives qualified dividend income from either the C corporation investments it makes or from the flow through of qualified dividend income from the K-1s of underlying partnerships.
1940 Act MLP funds have a unique set of issues that are not seen in other 1940 Act funds, this article touches on only a few of these major items. As the unique tax characteristics of both the MLP RIC fund and the MLP C corporation fund drive many of the operational issues of the fund, it is imperative that management have a deep level of understanding of these issues to properly oversee and coordinate the various parties that are needed to service the funds. Service providers of these funds should understand, in great detail, the complexities of the product and have in place a service offering that may substantially differ from their offering to traditional 1940 Act Funds. Finally, board members of the MLP funds must share a similar understanding as they provide that high level of oversight to the fund.
In addition to providing traditional independent audit services to MLP Funds, Cohen & Company Investment Industry Services Division has developed a team of professionals that provide outsourced tax solutions to funds, working with fund managers and administrators to effectively manage the unique characteristics of these funds.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.