Energy midstream companies organized as master limited partnerships (MLPs) offer significant tax advantages to investors. However, there are a few “gotchas” with MLP investing, so it is essential to correctly structure how you get exposure to this very attractive type of income investment.

Let me show you. Believe me, you’ll be grateful you read this come (next) tax season…

An investor in an MLP is technically a limited partner. The distributions/dividends paid to LP investors are classified as non-taxable return of capital. The MLPs earn the cash, but the structure makes income paid non-taxable.

MLP investors receive Schedules K-1 to use at tax reporting time. The nature of the MLP structure keeps distributions paid tax-exempt. Distributions reduce an investor’s cost basis, so they would be recaptured taxwise if the investor were to sell the MLP shares.

K-1 reporting investments can cause significant tax problems if owned in a qualified plan, such as an IRA or Roth IRA. Do not own MLPs in your retirement accounts. You have been warned.

I recommend investing in MLPs through a packaged product. Investing through an MLP-focused fund eliminates the K-1 problems but should pass through the tax advantages.

Which brings me to the main point of this article. I recently learned that the J.P. Morgan Alerian MLP Index ETN (AMJ) is structured as an exchange-traded note (ETN). Yes, I realize it says so right in the name, but I had not paid close attention to this MLP sector product. AMJ matures in May 2024 and will then be replaced with a similar ETN with the symbol AMJB.

ETFtrends.com gives this explanation concerning ETNs:

ETNs are senior, unsecured debt securities issued by a bank. Unlike ETFs, ETNs do not own the underlying assets that their return tracks. Furthermore, the return of an ETN is linked to a market index or other benchmark.

The ETN structure was developed in 2006. ETNs made it easier for retail investors to invest in hard-to-access instruments, particularly within commodities and currencies.

While both will provide a Form 1099 for taxes (i.e., no Schedule K-1), a key difference between MLP ETNs and ETFs is tracking error. Tracking error can be a concern with MLP ETFs given fund-level taxation. However, ETNs minimize tracking error.

ETNs generally do not pay any dividend or interest rate payments to investors because they do not hold any portfolio securities, but MLP ETNs do pay a variable coupon linked to the cash distributions paid by the MLPs in the index.

In this case, I think using an ETN is the lazy way out. This fund structure is popular in Europe, where it is very difficult for ETFs to get trading approval in all of the different stock exchanges. That is not the case in the U.S.

Also, AMJ/AMBJ will pay fully taxable dividends as interest income. Investors will not get the tax benefits of investing in MLPs.

My recommended MLP investment is the InfraCap MLP ETF (AMZA). This fund pays monthly dividends and currently yields 8.4%. AMJ yields just 6.2%.What a deal—AMJ gives a lower yield that will be taxed at a higher rate.