Master limited partnerships: tax and investment issues.
Origins of MLPs
In 1981, Apache Petroleum Company became the first limited partnership with equity claims to be traded on a major exchange. Some observers touted these creative new investment vehicles, while others condemned them as a tax dodge (William T. Moore, Donald G. Christensen, and Rodney L. Roenfeldt, "Equity Valuation Effects of Forming Master Limited Partnerships," Journal of Financial Economics, vol. 24, no. l, 1989). Their popularity increased until December 1987, when their key tax advantages were curtailed by the Omnibus Budget Reconciliation Act. Since 1987, many MLPs are limited to operations that earn 90% of their income from natural resources, commodities, or real estate, and limited types of passive income. Currently, there are 98 MLPs, the majority operating in the natural resources industry, of which about half have gone public in the past three years.
Nature of MLPs
MLPs are publicly owned limited partnerships whose units trade like the shares of a corporation. The owners of these units are a general partner and limited partners. The general partner usually holds a small minority percentage of the outstanding units, manages the partnership, is reimbursed for administrative costs, and is often given incentive rights. These rights reward the general partner with cash distributions if certain conditions are met. In contrast to the general partner, the limited partners usually hold a majority of the ownership units but have little voice in the MLP's operations.
The MLP's main purpose is to generate cash distributions to unitholders. The MLP structure is highly appropriate for stable growth and high cash-flow-generating enterprises. These operations often include oil and gas pipelines, contract coal production, and long-lived natural resource assets.
The MLP structure allows the passthrough of net income to the limited partners without being subject to federal or state income tax at the MLP level. This eliminates the double taxation of distributions and thus lowers the cost of capital. This often allows MLPs to outbid their corporate competitors, thereby setting the stage for higher growth through acquisitions. (See D. Van Dyke, and T. Pearson, "Coming to Canada," CA Magazine, January/February 2008, for a more detailed discussion of the above issues.)
The attractiveness of MLPs increased subsequent to the Tax Reform Act of 1986 (TRA 86; P.L. 99-514). TRA 86 reduced both corporate and individual marginal tax rates, and moved the top individual marginal tax rate (28%) below the top corporate marginal tax rate (35%). TRA 86 also removed preferential capital gains tax rates for corporate filers. This increased the attractiveness of the MLP, because it eliminated corporate double taxation, and income could be passed through to owners with lower marginal tax rates and preferential capital gains tax rates. Fearing tax revenue erosion, the ability of an entity to operate as an MLP was diminished when IRC section 7704 was added (Omnibus Budget Reconciliation Act of 1987; P.L. 100-203).
IRC section 7704 placed restrictions on which entities could operate as MLPs. Only entities with qualifying income of at least 90% could continue to utilize the MLP tax benefits. Qualifying income includes various types of passive income [IRC section 7704(d)(1)]. Most organized MLPs fall within the natural resources industry. Thus, the most popular type of passive income generated by MLPs is included in IRC section 7704(d)(1)(E)--income and gains derived from 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).
More recent legislation that has impacted MLPs includes the Jobs and Growth Tax Reconciliation Act of 2003 (JGTRA; P.L. 108-27), the Tax Increase Prevention and Reconciliation Act of 2005 (TTPRA; P.L. 109-222), and the American Jobs Creation Act of 2004 (AJCA; P.L. 108-357). Not only is passthrough income today subject to lower individual income tax rates, but capital gains are also subject to lower rates than in 1987. JGTRA reduced capital gains tax rates to 5% (taxpayers in the 10% or 15% brackets) and 15% (all other taxpayers). JGTRA also reduced the capital gains rate to zero (taxpayers in the 10% or 15% brackets) for tax years after 2007. TIPRA extended the 0/15% capital gains rates through 2010. The AJCA modified IRC section 851 (regulated investment companies) to increase the amount of net income, as a function of ownership limitations, from MLPs as qualifying income. This gives institutional investors the opportunity to own MLP units.
MLPs are similar to traditional partnerships. Specifically, an MLP is a non-taxable entity that passes through income, gains, deductions, and losses to its owners (unitholders). The passthrough items are reported to the unitholders via a Schedule K-l information return. MLPs are subject to more stringent passive income rules and therefore present ownership obstacles for tax-exempt entities.
Ownership interest (basis, income, and cash distributions). The partnership form tracks two bases, the owner's interest (outside basis) and the partnership's basis in the assets owned (inside basis). The outside basis usually equals the owner's proportionate share of the partnership's assets and liabilities. There is a potential mismatch, however, with secondary ownership unless the MLP has a basis adjustment election (IRC section 754) in place.
Outside basis begins with the owner's investment in the partnership. The outside basis is adjusted for passthrough items, debt, and distributions including cash. [See IRC sections 705, 732, 733, and 752. A full discussion of debt is beyond the scope of this article; refer to IRC section 752 and Treasury Regulations section 1.752-3(a) for more information.]
Owners are taxed on their share of income, but cash distributions are not taxed as long as they do not exceed outside basis. Since MLPs often own depreciable operational assets and depletable natural resources, the depreciation and depletion can be used by the unitholder as a tax shield.
Example 1. Owner X buys 1,000 units of Petro MLP at $50 each on January 1, 2008. X's outside basis is $50,000 on January 1, 2008. At the end of the tax year, X receives Petro MLP's K-l with the passthrough items. X increases outside basis by $1,000 of income and decreases outside basis by $700 of depreciation. X also receives a cash distribution of $10,000. X's outside basis prior to the cash distribution is $50,300 ($50,000 + $1,000 -$700), and $40,300 ($50,300-$10,000) after the cash distribution. X will have $300 of taxable income, and the cash distribution is a tax-free return of basis. The $300 of income is taxed at the owner's marginal tax rate unless it is a capital gain passthrough item.
MLPs make cash distributions in excess of what is needed for the next operating cycle, and generally these are a tax-free return of basis. When the cash distribution exceeds the owner's outside basis, it is treated as a capital gain as if the partnership interest were sold (IRC sections 731 and 741; IRC section 751 is discussed below). Moreover, the depreciation and depletion will offset the amount of taxable income each owner must report. This tax shield will diminish as the long-lived assets mature (i.e., are fully depreciated or depleted) and less depreciation/depletion is passed through to the unitholders unless the MLP continues to invest in capital assets.
The other contingency on depreciation/depletion passthroughs relates to secondary ownership. To profit from the investment, an existing owner would typically sell the ownership interest (units) for more than the current outside basis. The secondary owner's outside basis would then exceed the proportionate share of the inside basis. If the MLP has made an IRC section 754 election, the inside basis is adjusted upward by the excess of the outside basis (purchase price plus share of partnership liabilities) versus the proportionate inside basis (see IRC section 755 for the basis adjustment allocation), but only for the new owner. The section 754 election can also result in a downward adjustment if the market is in decline. The basis adjustment ensures the new owner receives a depreciation/depletion adjustment that reflects fair market value (recent purchase price) rather than the partnership's inside basis. Hence, the new owner receives a larger (smaller) depreciation/depletion deduction when the market is up (down).
The example above included a net income passthrough and a cash distribution. When a traditional partnership passes through a loss, it is first limited to the owner's outside basis (IRC section 704), then the at-risk amount (IRC section 465), and then passive activities (IRC section 469). In the event the MLP passes through a loss, the unitholders are subject to special passive loss limitation rules. Unitholders must suspend the loss, and cannot use it until the same MLP passes through income that can be offset.
Passive Activity limitation. Since MLPs must generate passive activity income under IRC section 7704, owners are subject to passive activity rules. Investors can generally offset passive activity losses with passive activity income regardless of the source (IRC section 469), but MLP investors are subject to a more stringent passive activity rule under IRC section 469(k). MLP investors can offset only against the same MLP investment.
Example 2. Owner X has outside basis of $40,300. If Petro MLP passes through a loss of $3,000, X cannot use the loss in the current year even though X has sufficient outside basis. X must suspend the investment loss until it has passthrough income from Petro MLP.
The suspended losses can be used to offset any income when the complete MLP ownership interest is sold [IRC section 469(g)]. The losses are applied first to any MLP income or gain from disposition, second to any passive activities, and finally to any other income or gain.
IRC section 751 (sales and exchanges). As with traditional partnerships, MLPs are not immune to IRC section 751. MLP investors cannot escape taxation on their share of ordinary income. The general rule for the sale of a partnership ownership interest is that sales in excess of basis result in capital gain; however, IRC section 751 subjects a portion of the realized gain to ordinary income treatment. Both sales and exchanges result in ordinary income to the extent the sale proceeds are attributable to the owner's proportionate share of unrealized receivables and inventory. Both unrealized receivables and inventory are liberally construed [IRC sections 751(c) and 751(d)]. This means that unrecaptured depreciation for realty (IRC section 1250) and personality (IRC section 1245) will be considered ordinary income, as well as recapture of intangible drilling and development costs of oil and gas wells, and mining development and exploration expenditures (IRC section 1254).
Example 3. At the end of 10 years, Owner X has outside basis of $80,000 (original cost basis $50,000). Owner X sells all the Petro MLP units for $100,000. The realized gain is $20,000 ($100,000 -$80,000). Generally, the gain would be treated as capital (IRC section 741), but $10,000 of the sales amount is attributable to recapture and considered IRC section 751 property. The $80,000 basis must be allocated between capital gains and ordinary income. Ninety percent ([$100,000-$10,000] / $100,000) of the sale proceeds and basis is allocated as IRC section 741 capital gain, and 10% ($10,000 /$100,000) as IRC section 751 property. The capital gain is $18,000 [$90,000 (90% x $100,000 sale proceeds)-$72,000 (90% x $80,000 basis)] and the ordinary income is $2,000 [$10,000 (10% x $100,000 sale proceeds)-$8,000 (10% x $80,000 basis)].
Individual taxpayers would apply the appropriate preferential capital gains tax rate (0/15%) to the $18,000 capital gain and their marginal tax rate to the $2,000 ordinary income.
Generally, tax-exempt entities [charitable organizations, IRAs, 401(k) plans, and pension plans] should not directly invest in MLPs because the income is considered unrelated business taxable income (UBTI; see IRC section 511). A nominal investment may be tolerable, because tax-exempt entities are not subject to UBTI tax unless the income exceeds $1,000. Until the AJCA in 2004, regulated investment companies (mutual funds) were required to derive 90% of income from qualifying sources, leaving only 10% of the income to be derived from other sources such as MLPs. The AJCA modified IRC section 851 so that mutual funds can include MLP income as part of the 90% qualifying income. The fund's MLP ownership is limited to no more than 10% ownership in any one MLP [IRC section 851(b)(3)(A)].
Changes resulting from the AJCA give tax-exempt entities the ability to invest in MLPs via a mutual fund without being subject to the UBTI rules. In 2001, prior to the AJCA, Goldman Sachs created a limited liability company (LLC) to invest in Kinder Morgan Energy Partners. The LLC paid stock dividends equivalent to the cash distributions it received from Kinder MLP. This provided tax-exempt entities an indirect ownership in the MLP. Similarly, Bear Stearns issued its exchange-traded note (ETN) which is tied to an index of MLPs. The BearLinx Alerian MLP Select Index ETN was issued on the New York Stock Exchange in July 2007 (www.nyse.com/press/ 1184928629497.html). The ETN also provides tax-exempt entities a way to achieve an indirect ownership in the MLP.
The MLP completes a K-1 information return rather than a Form 1099 [for corporate distributions (F1099-DIV) and sales (F1099-B)]. Each unitholder receives a Schedule K-1 from the MLP at the end of the tax year. The K-1 shows the allocation of ordinary income and separately reported items (e.g., capital gains) to the owner. Unitholders use the K-1 to complete their own tax return. Individual taxpayers will complete their Form 1040, Schedule E (Supplemental Income and Loss) Part II with the information included on the K-1.
When the unitholder sells units, the MLP will provide a sales schedule detailing the sales proceeds, basis information, and ordinary versus capital gain. The ordinary gain is reported on Form 4797, Part II, and capital gain on Schedule D.
Prospective investors should investigate potential state income tax liabilities since income is source-based. If the MLP operates in a state other than the owner's resident state, the owner may be subject to state income tax in another state. At least two states, Massachusetts and Virginia, have issued rulings whereby nonresident individual taxpayers can participate in a composite income tax filing as long as they do not have any other income from the nonresident state (see Letter Ruling 1988-2, Massachusetts Department of Revenue; Ruling of Commissioner, P.D. 87-144, Virginia Department of Taxation).
Alternatively, a win-win investment could occur if the MLP operates only in a state with no personal income tax and the investor resides in a state with no personal income tax. The seven states with no personal income tax include: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Two additional states, New Hampshire and Tennessee, tax only dividends and interest income. Unless the MLP passes through investment income, prospective investors have nine states where personal income taxes would not apply.
Risks. Although IRC section 7704 has offered benefits to applicable MLPs for two decades, tax law is subject to change. Historically, MLPs were allowed a 10-year transition period to satisfy the IRC section 7704 requirements, but this is no guarantee. Moreover, tax-neutral legislation is preferred in the current political climate, which means changes to the existing MLP laws (e.g., all MLPs treated as corporations) that generate additional tax revenue could be targeted by lawmakers to offset other tax cuts.
Conversely, a change to corporate tax law could make the MLPs less attractive. For example, corporate marginal rates could decrease or corporations could be treated as passthrough entities (see "UNC Professor Recommends Taxing C Corps as Passthrough Entities," Tax Analysts, DOC 2008-12446).
MLP Investment Vehicles
There are a variety of ways to purchase MLP units individually, as well as indirectly, through the purchase of shares of closed-end funds (CEF) specializing in MLPs.
Today there are nearly 100 publicly traded MLPs in industries ranging from energy pipelines to the financial sector. Exhibit 1 lists representative partnerships in the various sectors and typical current dividend yields for that sector (www.naptp. org/PTP101/CurrentPTPs.htm). With a typical yield of approximately 7.5%, some investors may find these secure income returns attractive. As explained above, however, owning MLP units directly can present some tax issues, such that owning shares in MLP CEFs may be more appropriate.
EXHIBIT 1 Representative MLPs by Sector Sector Company Exchange Yield Energy Pipelines Buckeye Partners, LP. NYSE 8.9% Hiland Partners, LP. NASDAQ 7.9% ONEOK Partners, LP. NYSE 7.6% Williams Partners, LP. NYSE 9.1% Propane Americas Partners, LP. NYSE 8.3% Transport OSG America, LP. NYSE 11.9% Coal Alliance Holdings GP, LP. NASDAQ 5.9% Exploration Legacy Reserves, LP. NASDAQ 9.9% Real Estate NTS Realty Holdings, LP. AMEX 6.5% Financial The Blackstone Group, LP. NYSE 6.1% Other Cedar Fair, LP. NYSE 8.4%
Exhibit 2 lists 10 publicly traded MLP-oriented CEFs. For example, the profile of Kayne Anderson Energy Total Return Fund (KYE; www.kaynefunds.com/KyeNav.htm) is representative of funds in the industry:
EXHIBIT 2 Closed-End MLP Funds Company Exchange Yield BlackRock Global Energy and Resources Trust NYSE 5.2% Fiduciary/Claymore MLP Opportunity Fund NYSE 7.8% Fiduciary Energy Income and Growth Fund AMEX 8.2% Kayne Anderson Energy Development Co. NYSE 6.8% Kayne Anderson Energy Total Return Fund NYSE 8.4% Kayne Anderson MLP Investment Co. NYSE 7.6% Tortoise Capital Resources Corp. NYSE 9.1% Tortoise Energy Capital Corp. NYSE 7.8% Tortoise Energy Infrastructure Corp. NYSE 7.8% Tortoise North American Energy Corp. NYSE 7.4%
Kayne Anderson Energy Total Return Fund is a non-diversified, closed-end investment company. Our investment objective is to obtain a high total return with an emphasis on current income by investing in securities of companies engaged in the energy industry. ... In addition to MLPs and their affiliates, KYE also invests in U.S. and Canadian royalty trusts and income trusts, marine transportation, and other companies that derive at least 50% of their revenues from operating assets used in, or providing energy related services. Our focus is on niche asset classes within the energy sector that are under-followed or misunderstood by the general investment community. We invest in publicly traded securities and up to 50% of our assets may be in privately negotiated securities of energy and energy infrastructure companies.
In addition to their diversification benefits, one characteristic of CEFs that some investors find attractive is that CEF shares sometimes sell at a discount to their net asset value (NAV) per share of the fund's holdings. For example, KYE currently has a NAV of approximately $30 per share and trades at $18 in the market (a 10% discount). Such a discount helps offset the effect of the management fee expense charged by the fund.
Therefore, an investor may prefer to buy CEFs specializing in MLPs for several different reasons:
* The CEF handles the tax paper work that MLPs often require at year-end.
* Buying a CEF gives the investor instant diversification because of its broad range of holdings.
* If the CEF can be purchased at a discount to NAV, the amount of the discount helps offset the impact of the annual management fee on the investor's return.
Investors looking for the highsssss-currentdividend yields and participation in various industries that MLPs can provide should consider them as an investment option. Because the direct ownership of MLP units impacts both taxable and nontaxable investors differently than does ordinary common stock ownership, potential investors should also consider MLP-oriented CEFs as a way to participate in this market. Investors should seek financial planning advice that considers the tax and financial implications of their particular circumstances.
Lynn Comer Jones, PhD, CPA, is an assistant professor of accounting at the University of North Florida, Jacksonville, Fla. Johnny Johnson is an instructor of accounting at Tuskegee University, Tuskegee, Ala. Seth C. Anderson, PhD, is a professor of finance, also at Tuskegee University.
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|Author:||Jones, Lynn Comer; Johnson, Johnny; Anderson, Seth C.|
|Publication:||The CPA Journal|
|Date:||Dec 1, 2008|
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