2013 - Issue 8—What are master limited partnerships, or MLPs? Why have I been hearing so much about them lately? Well, MLPs have been in existence since the early 1980s. In fact, Apache Petroleum Company MLP was created in 1981 as an attractive way to raise capital by offering small investors a partnership investment in a liquid security. Congress felt it was important to limit the type of businesses that could avoid an entity-level tax and still be publicly traded while encouraging investment in domestic energy infrastructure. So, in 1987, Congress enacted Internal Revenue Code Section 7704, and a tax-advantaged entity was born that combined the benefits of partnership taxation with the public features of exchange-traded C corporation stock — most notably, access to public capital as a source of funds for capital expenditures and other corporate purposes.
The MLP's recent notoriety is due to its offering relatively high yields (in a world where yields have shrunk if not all but disappeared) and tax deferral (very favorable, especially in light of rising tax rates) with exposure to a domestic energy infrastructure asset class.
Publicly Traded Partnerships Are Generally Taxed as C Corporations — Subject to an Entity-Level Tax
Generally, partnerships whose interests are traded on an established exchange (or are readily tradable on a secondary market), known as publicly traded partnerships, are not entitled to the favorable pass-through treatment afforded to other non-publicly traded partnerships. Instead, Section 7704(a) of the Internal Revenue Code treats such publicly traded partnerships (PTPs) as corporations, thus imposing an entity-level tax on the PTP. However, as is generally the case, there is an exception for partnerships with passive-type income.
Certain PTPs Can Avoid the Entity-Level Tax
Under Code Section 7704(c), PTPs are relieved from corporate treatment under Section 7704(a) if 90 percent or more of their gross income is qualifying income, which includes generally:
- Passive income (interest, dividends, capital gains and rents from real estate);
- Income and capital gains from commodity investments; and
- Income and gains derived from active businesses engaged in the exploration, development, mining, or production, processing, refining, transportation (including pipelines transporting gas, oil or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber), industrial-source carbon dioxide, or the transportation or storage of any fuel described in subsection (b), (c), (d) or (e) Code Section 6426 (credit for alcohol fuel, biodiesel and alternative fuel mixtures), or any alcohol fuel defined in Code Section 6426(b)(4)(A) or any biodiesel fuel as defined in Code Section 40A(d)(1).
Examples of Qualifying Income
There are over 100 MLPs trading on the markets today with over $335 billion of capital (as of late 2012), the majority of which are operating in industries relating to energy and natural resources. Remember our definition of qualifying income from above? In particular, it is the midstream energy business category that has drawn capital to PTPs, or what are more commonly seen as MLPs. The familiar MLPs in this space (gathering, processing, compression, transportation and storage) include Enbridge Energy Partners LP and Kinder Morgan Energy Partners LP. There are others involved in exploration and production of crude and gas, like Constellation Energy Partners LLC, and others in mining, like Hi-Crush Partners LP. There are some financial institution MLPs, like Alliance Bernstein Holding LP, Apollo Global Management LLC, The Blackstone Group LP, Icahn Enterprises LP and Lazard Ltd. In addition, the IRS recently ruled in 2012 that companies providing services to the gas fracturing business, including the removal, treatment, recycling and disposal of waste products generated by fracking, earn qualifying income. The IRS also ruled in 2012 that income derived from the processing of natural gas liquids into olefins was qualifying income.
There are also some unique ones, like StoneMor Partners LP (the only publicly traded death care company structured as an MLP), Royal Hawaiian Orchards LP (processes nuts-in-shell into macadamia kernel and markets the nuts in both bulk form and branded products, including fruits and macadamia crunches and seasoned macadamias) and Cedar Fair LP (one of the largest regional amusement park operators in the world, with eleven amusement parks, four separately-gated outdoor water parks, one indoor water park and five hotels).
The point is that MLPs were allowed to operate any business prior to 1987, the date Congress defined publicly traded partnerships and limited their income to the sources discussed above. Those MLPs with "bad" income were grandfathered under the new law and permitted to maintain their flow-through status. Most of those have converted to corporations or been acquired. But as discussed above, some still remain in the partnership form. Congress is also debating bills that would now expand the definition of qualifying income to include other sources such as renewable energy sources and related infrastructure projects.
General Tax Rules for MLPs — Essentially, a Primer on Partnership Taxation
Partnership Income — As a partnership, an MLP is not subject to tax itself, but rather the partners (or unitholders) report their share of the partnership income (or loss) on their tax returns and pay the associated tax at their rates as if the unitholders earned the MLP income themselves. This happens annually without regard to cash distributions from the MLP. Each unitholder receives a Schedule K-1 from the MLP reporting that unitholder's share of partnership items. If there is a net loss from the MLP, it cannot be used to offset other income earned by the unitholder. Instead, the loss is suspended and carried forward and used against income from the same MLP interest when generated.
Partnership Distributions — The first thing to keep in mind is that a unitholder's cash distribution is not correlated to the amount of income or loss that is reported to the unitholder on their Schedule K-1 for the year of the distribution. Distributions are normally the sum of (x) net income, (y) increased by depreciation deductions that are not cash items and (z) decreased by repairs and maintenance capital expenditures (amounts needed to maintain and repair income-producing assets). Second, as long as a unitholder has positive tax basis in the MLP units, the distributions related to those units are not subject to current taxation. Instead, the unitholder is required to reduce the tax basis in the MLP units by the amount of the distribution. As long as the unitholder maintains a positive tax basis in the units, the cash distribution is tax-deferred. The distribution is tax-deferred because the reductions to tax basis for distributions will later produce a larger tax gain or lower tax loss when the holder disposes of the units.
Partnership Tax Basis — A unitholder's tax basis in the MLP units is very important. The tax basis shields distributions from current taxation (explained above) and it is offset against proceeds upon eventual sale of the units, reducing the amount of gain recognized on the disposition. A unitholder's tax basis is the initial cost of the units purchased increased by the amount of income reported on Schedule K-1, reduced by the amount of loss reported on Schedule K-1, increased by additional capital contributions made to the partnership and reduced by distributions from the partnership. As long as a unitholder's tax basis in the units is positive, cash distributions will remain tax-deferred. Upon a unitholder's death, the tax basis in the units might be stepped up to fair market value and, thus, the tax-deferred distributions convert to tax-free distributions. That is, there is no recapture of the prior distributions as taxable in the future because the unit's tax basis might be stepped up at the death of the holder.
Character of Gain on Disposition of Partnership Interest — Generally, gain or loss on the disposition of an MLP unit is capital gain or loss. However, there is an exception for partnerships with substantially appreciated inventory and unrealized accounts receivables on their books at the time the unitholder disposes of the units. Any gain on the disposition of the MLP units that is allocable to the unitholder's share of these "hot assets" is recharacterized as ordinary gain. Also, depreciation deductions previously reported to the unitholder on Schedule K-1 are recaptured as ordinary income. Those deductions previously reduced the amount of ordinary income that the unitholder picked up on its tax returns. Any remaining amount of gain in excess of the sum of (x) the amount of hot assets allocable to the unitholder and (y) the amount of depreciation deductions on previously reported Schedule K-1 will be taxed as a capital gain.
Myths Exposed: Recent Proposed Partnership Taxation Changes to the Carry and Dividend Tax Rates
The Carry — Recently and over the course of the past few years, we have heard a lot of discussion on taxing certain partnership items as ordinary income versus capital gain. Most of the noise has centered on investment advisors taking a piece of their fee in a partnership interest form. The perception is that advisor partners who earn a percentage of their fees in the form of a partnership interest have converted ordinary income (wages) into capital gains when the partnership interests are eventually sold. The partnership percentage earned by the advisor partners is known as the "carry." Most proposed legislation that has sought to correct this "loophole" in the tax law would not affect MLP taxation, as MLP unitholders are not advisor partners. The MLP unitholders report their income as if they were directly earning it from the MLP by picking up the Schedule K-1 items from the MLP and putting them on their own tax returns. Thus, the MLP unitholders do not earn the "bad" carry income that is capital in nature. Also, the MLP itself is earning active income and not capital gains. Therefore, most proposed laws we have seen would not affect an MLP or its unitholders. What we have seen, in proposed form only, would convert the carry income into ordinary income. The rules would be limited to a carry and also limited to advisor partners. MLP unitholders do not earn a carry and are not advisor partners.
Increased Tax Rate on Dividends — The recent "fiscal cliff fix" that resulted in a 5 percent increase in the tax rates applicable to dividends for wealthy taxpayers should not have a negative impact on the unit price of MLPs. The reality is that MLPs do not (and never did) pay dividends subject to any tax rate. Remember that as a unitholder in a partnership, you receive a Schedule K-1 (as opposed to a Form 1099-DIV that would come from a regular C corporation), and the tax applicable to Schedule K-1 income or loss has always been the unitholder's regular tax rates. Therefore, MLP unit prices have generally not been affected by decreases or increases to dividend tax rates.
Dreams Revealed — Partnership Parity Act
Originally, MLPs were limited to investing in assets that could give rise to mining and natural resources income identified in Code Section 613 (percentage depletion). In 2008, the Emergency Economic Stabilization Act expanded the definition of MLPs to include those earning income from transportation and storage of certain renewable and alternative fuels (ethanol, biodiesel and a list of liquefied fuels) and industrial-source carbon dioxide.
The Master Limited Partnerships Parity Act (proposed in 2012) would further expand the definition of qualifying income to include income earned from renewable sources and related infrastructure projects. Specifically, the technologies identified in Code Sections 45 (electricity produced from certain renewable resources, etc.) and 48 (energy credit), including wind, closed and open loop biomass, geothermal, solar, municipal solid waste, hydropower, fuel cells, and combined heat and power, would be defined to generate qualifying income for MLP purposes. The MLP Parity Act would not affect any other MLPs currently in place or their taxation.
Alvarez & Marsal Taxand Says:
MLPs are firmly entrenched, with the number of such businesses over 100 and growing. If the MLP Parity Act were to pass Congress, the growth in the MLP space could be beyond huge. That could create another vehicle for investors with the ability to use the production tax credits or investment tax credits associated with renewable energy electricity production. Hence, there would be more capital chasing the MLP market. In addition, tax increases like the recent 5 percent change in dividend taxation (for the high-income earners) also might lead more investors to include the MLP sector in their decision process.
As the investor base and interest in these assets continue to grow, and as the types of assets available for and capital deployed into MLPs continue to grow, tax professionals must become conversant with partnership taxation and how these things work. There are other nuances that I will address in future articles. In the next article jointly authored by me and one of our team members in Business Consulting, we will focus on IPO readiness issues that need to be addressed as MLPs are considered in your business.
For now, if your company is sponsoring an MLP or you are directly employed by an MLP in the tax department, having a working knowledge of partnership taxation and MLPs is invaluable. Once public, they are treated as separate businesses from their sponsors and run independently. The tax department will be a key member of the finance organization for an MLP sponsor or the MLP itself. A working knowledge of MLP issues is imperative.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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