By: Steven D. Hamilton, Principal, Steven D. Hamilton, CPA

August 21, 2014 12:08 pm EDT
MT Empire StateENLARGE
MT Empire State is a Kinder Morgan tanker operating under long-term charter by the Military Sealift Command Photo: Kinder Morgan

I am reading that Kinder Morgan, Inc (KMI) is restructuring, bringing its master limited partnerships (MLPs) under one corporate structure. We have not spoken about MLPs in a while, and this gives us an opportunity to discuss what these entities are. We will also discuss why a company would reconsolidate, especially in an environment which has seen passthrough entities as the structure of choice for so many business owners.

As a refresher, a plain–vanilla corporation (which we call a “C” corporation) pays tax at the corporate level. The United States has the unenviable position of having one of the highest corporate tax rates in the world, which is certainly a strike against organizing a business as a C corporation. Couple this with the tax Code’s insistence on taxing the worldwide income of a C corporation (with certain exceptions), and there is a second strike for businesses with substantial overseas presence.

A passthrough on the other hand generally does not pay tax at the entity level. It instead passes its income through to its owners, who then combine that income with their personal income and deductions (for example, salary, interest and dividends, as well as mortgage interest and real estate taxes) and pay taxes on their individual tax returns. This is a key reason that many tax professionals are opposed to ever-higher individual tax rates. The business owner’s personal income is artificially boosted by that business income, pushing - if not shoving - him/her into ever-higher tax rates. This is not generally interpreted as an admonition from our government to go forth and prosper.

MLPs are relatively recent creations, entering the tax Code in 1986. They can be the size of publicly-traded corporations, but they are organized instead as publicly-traded partnerships. They are required to generate at least 90% of their revenues from “qualifying sources,” commonly meaning oil, natural gas or coal. The stock market values MLPs on their cash flow, so the sponsor (in this case, KMI) has great incentive to maximize distributions to the unitholders. MLPs have consequently become legitimate competitors to bonds and dividend-paying stocks. You could, for example, purchase a certificate of deposit paying 1.4%, or you could instead purchase a MLP paying 7%. Introduce a low interest rate environment, couple it with expanded activity in shale and natural gas, and MLPs have been in a very favorable investment environment for a while.

One of the granddaddies of MLPs is Kinder Morgan Inc, which placed its operating activities in three principal MLPs: Kinder Morgan Energy Partners, Kinder Morgan Management and El Paso Pipeline Partners. To say that they have done well is to understate.

There is a tax downside to MLP investing, however. A MLP does not pay dividends, as Proctor & Gamble would. Instead it pays distributions, which may or may not be taxable. You do not pay tax on the distributions per se. You instead pay tax on your distributable income from the MLP, reported on a Schedule K-1. A partner pays tax on his/her income on that K-1; by investing in a MLP you are a partner. To the extent that the K-1 numbers approximate the distribution amount, your tax would be about the same as if you had received a dividend. That, however, almost never happens. Why? Let’s look at one common reason: depreciation. As a partner, you are entitled to your share of the entity’s depreciation expense. Depreciation reduces your share of the distributable income. To the extent that there is heavy depreciation, less and less of your distribution would be taxable. What type of entity would rack up heavy depreciation? How about a pipeline, with hundreds of millions of dollars tied-up in its infrastructure?

This leads to an (almost) win:win situation for the investor. To the extent there is outsized depreciation, or perhaps depletion or tax credits, you can receive generous distributions but pay tax on a considerably smaller number. There is a tax downside however. To the extent that the distributions exceed the K-1 income, you are deemed to have received a return of your capital. This means that you are getting back part of your investment. This matters later, when you sell the MLP units. Your “basis” in the MLP would now be less (as your investment has been returned to you bit by bit), meaning that any gain on a subsequent sale would be larger by the same amount. Many MLP investors have no intention of ever selling, so they do not fear this contingency. No later sale equals no later tax.

Almost all MLPs pay someone to actually manage the business, whether it is a pipeline or timberland. That someone would be the sponsor or general partner (GP). The general partner receives a base percentage to manage the operations, and many MLPs also further pay an incentive distribution right (IDR) to the general partner, which amount increases as the MLP becomes more and more profitable. For example:

  • A GP receives 2% base to manage the business
  • Then there is an IDR at certain steps

o   At step one, the GP receives 15% of the increment over the first step,

o   At step two, the GP receives 25% of the increment over the second step,

o   At step three, he GP receives 35% of the increment over the third step

How high can this go? Well, KMI and its MLPs have done so well that approximately 50% is going to an IDR payment.

This means that KMI is receiving up to 50% of the MLP income it is managing, so 50% comes back to the KMI (a C corporation) anyway. One really has not accomplished much tax-wise as far as that 50% goes.

But that leaves the other 50%, right?

MLPs can have difficulty borrowing money because they pay-out such an outsized percentage of their income, whether as IDRs or distributions. A banker wants to see a profitable business, as well as see the business retain some of that profit, if only to repay the bank. This leads to complicated bank loans, as the GP has to step in as a borrower or a guarantor on any loan. Banks also like to have collateral. Problem: the GP does not have the assets; instead the MLP has the assets. This causes banking headaches. The headache may be small, if the MLP is small.  Let the MLP grow, and headaches increase in intensity.

Remember what we said about KMI? It is one of the granddaddies of MLPs. Banking and deal making have become a problem.

So KMI Inc has decided to do away with its MLP structure. It has proposed to buy back its MLPs in a $44 billion deal, bringing everything under the corporate roof. It now becomes the third largest energy company in the United States, behind only Exxon Mobil and Chevron.

The stock market seemed to like the deal, as KMI’s stock popped approximately 10% in one day.

What is the tax consequence to all this? Ah, now we have a problem. Let us use Kinder Morgan Energy Partners as an example. These investors will have a sale, meaning they will have to report and pay taxes on their gains. Remember that they have been reducing their initial investment by excess distributions. I have seen estimates of up to $18 tax per KMEP MLP unit owned. Granted, investors will also receive almost $11 in cash per unit, but this is a nasty April 15th surprise waiting to happen.

The restructuring should reduce KMI’s taxable income as much as $20 billion over the next dozen years or so, as KMI will now be able to claim the depreciation on its corporate tax return. In addition, KMI will be able to use its own stock in future acquisitions, as C corporations can utilize their stock to structure tax-free mergers. Standard & Poor’s has said it would upgrade KMI’s credit rating, as its organizational chart will be easier to understand and its cash flow easier to forecast. KMI has already said it would increase its dividend by approximately 10% annually for the rest of the decade.

By the way, are you wondering what the secret is to the tax voodoo used here? Kinder Morgan is bringing its MLPs onto its depreciation schedule, meaning that it will have massive depreciation deductions for years to come. There is a price to pay for this, though: someone has to report gain and pay tax. The IRS is not giving away this step-up in depreciable basis for free. It is however the MLP investors that are paying tax, although KMI is distributing cash to help out. To the extent that KMI optimized the proportion between the tax and the cash, the tax planners hit a home run.

The views and opinions expressed herein are those of the author(s). Core Compass’s Terms Of Use applies.

About the author

Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Kinder Morgan Inc. (KMI)Kinder Morgan Energy (KMP)master limited partnershipsC corporationpassthrough entitiesgeneral partner
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