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.
