A Hassle-Free Path to MLP Investing?

These days, many investors need as much investment income as they can find. Master limited partnerships have gained popularity in recent years precisely because they deliver lucrative income streams to their investors -- and often come with valuable tax benefits.

But even as we close the books on another tax season, the shortcomings of owning MLP units will likely remain on the minds of unitholders for some time. Below, I'll talk about some new exchange-traded funds that hope to get rid of those tax nightmares for good. But first, let's take a look at MLPs and the pros and cons of investing in them.

Feel the energy
High oil prices and a booming supply of natural-gas drilling have made oil and gas investments extremely popular. Many energy stocks feature attractive yields as a result, especially those focusing on oil and other liquids, where prices are particularly high.

But many energy companies pay huge amounts of taxes, offsetting their profits and reducing how much they have available to pay dividends. One way to get a tax advantage is to invest in what's known as pass-through entities, of which MLPs are an example. Because they qualify for favorable tax treatment, MLPs don't have to pay taxes like corporations do. They instead have to tell their unitholders what their respective share of each MLP's income is, and the investors then have to report that income on their own individual tax returns.

Avoiding the double taxation of being a corporation is a definite plus for MLPs and their investors, as well as the impact lower taxes have on their yields. Inergy (NYS: NRGY) with its massive 18% yield is definitely extreme even for MLPs, but with more sustainable yields in the 7% range, Linn Energy (NAS: LINE) and Energy Transfer Partners (NYS: ETP) still pay enough to top most conventional energy investments. But the downside is that the way that MLPs have to report their income to their unitholders -- using the infamous Form K-1 -- creates a huge accounting headache that can require multiple tax filings in various states as well as added complications on your federal return.

The ETF "solution"
Late last year, I wrote about how Alerian MLP ETF (NYS: AMLP) aims to solve the problem of K-1 tax reporting. By taking on full corporate status rather than the typical registered investment company structure that most ETFs use, Alerian MLP ETF is able to treat its investors as regular shareholders rather than MLP unitholders, and thus it doesn't have to send out K-1s or create big tax complications. But there's a huge downside: As a regular corporation, the ETF has to pay taxes -- and those taxes have greatly reduced the returns the ETF has produced over its history. Since the Alerian MLP ETF's inception, its tracking index has returned more than 21% per year -- but the ETF shares themselves only had a return of 13%.

The new ETFs that focus on MLP investment use the same corporate structure as their Alerian counterpart. Both Global X MLP ETF and Yorkville High Income MLP ETF include provisions in their prospectuses that discuss the potential impact that their corporate tax liability will have on their net asset values, so it's reasonable to conclude that they'll face similar return shortfalls.

Pick your poison
Of course, even 13% annual returns sound pretty good in the current market environment, so you might be inclined to say that saving the tax hassle is worth it. Moreover, the tax impact also acts as a brake on declines as well, as it allows the funds to reduce their tax reserves.

But the complications are just another way that investors can get surprised by complex investments. Just as United States Natural Gas (NYS: UNG) has failed to track the long-term changes in the spot price of natural gas, so too has the Alerian MLP ETF failed to match the returns available on MLPs. In all likelihood, the new ETFs will face the same problem.

MLP ETFs save you from tax hassles, but at the severe cost of a big tax hit. Before you invest, you have to decide whether reduced returns are worth the convenience that MLP ETFs provide.

If you like energy stocks, we've got a stock idea that could knock your socks off. Read about it right here in The Motley Fool's special free report on the energy industry and its best prospects -- it's free but only available for a limited time, so click here today.

At the time thisarticle was published Fool contributor Dan Caplinger hates hassles. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is always hassle-free.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.