Why is Kinder Morgan Buying Its Own Master Limited Partnerships?

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.   

What Does It Take To Claim a Business Bad Debt Deduction?

Do you know what it takes to support a bad debt deduction?

I am not talking about a business sale to a customer on open account, which account the customer is later unable or unwilling to pay. No, what I am talking about is loaning money.

Then the loan goes south, other partially or in full.

And I –as the CPA - find out about it, sometimes years after the fact. The client assures me this is deductible because he/she had a business purpose – being repaid is surely a business purpose, right?

Unless you are Wells Fargo or Fifth Third Bank, the IRS will not automatically assume that you are in the business of making loans. It wants to see that you have a valid debt with all its attributes: repayment schedule, required interest payments, collateral and so forth. The more of these you have, the better your case. The fewer, the weaker your case. What makes this tax issue frustrating is that the tax advisor is frequently uninformed of a loan until later – much later – when it is too late to implement any tax planning.

Ronald Dickinson (Dickinson) and Terry DuPont (DuPont) worked together in Indianapolis. DuPont moved to Illinois to be closer to his children. DuPont was having financial issues, including obligations to his former wife and support for his children.

Dickinson started up a new business, and he reached out to DuPont. Knowing his financial issues, Dickinson agreed to help:

Anyway, I want to reiterate again my commitment to you financially, and what I would expect from you in paying me back. I am not going to prepare a note, or any form of contract, because I trust you to be honest about this matter, just like all of the other people I have loaned money.

Anyway, I agree you loan you money to get settled in over here, and help you out financially as long as I see our new company is working, and you are going to work as hard as you did for me the last time we worked together.”

Sounds like Dickinson was a nice guy.

Between 1998 and 2002, Dickinson wrote checks to DuPont totaling approximately $27,000.

DuPont acquired a debit card on a couple of business bank accounts, and he helped himself to additional monies. He was eventually found out, and it appears that he was not supposed to have had a debit card. By 2003 the business relationship ended.

Dickinson filed a lawsuit in 2004. He wanted DuPont to pay him back approximately $33,000. The suit went back and forth, and in 2009 the Court dismissed the lawsuit.

Dickinson, apparently seeing the writing on the wall, filed his 2007 tax return showing the (approximately) $33,000 as a bad debt. He included a long and detailed explanation 0f the DuPont debacle with his return, thereby explaining his (likely largest) business deduction to the IRS.

The IRS disallowed the bad deduction and wanted another $15,000-plus from him in taxes. But - hey – thanks for the memo.

Dickinson took the matter pro se to Tax Court.

And there began the tax lesson:

(1)   Only a bona fide debt qualifies for purposes of the bad debt deduction.

(2)   For a debt to be bona fide, at the time of the loan the following should exist:

a.      An unconditional obligation to repay

b.      And unconditional intention to repay

c.       A debt instrument

d.      Collateral securing the loan

e.      Interest accruing on the loan

f.        Ability of the borrower to repay the alleged loan

Let’s be honest: Dickinson was not able to show any of the items from (a) to (f). The Court noted this.

But Dickinson had one last card. Remember the wording in his letter:

            … just like all of the other people I have loaned money.”

Dickinson needed to trot out other people he had made loans to, and had received repayment from, under circumstances similar to DuPont. While not dispositive, it would go a long way to showing the Court that he had a repetitive activity – that of loaning money – and, while unconventional, had worked out satisfactorily for him in the past. Would this convince the Court? Who knows, because…

… Dickinson did not trot out anybody.

Why not? I have no idea. Without presenting witnesses, the Court considered the testimony to be self-serving and dismissed it.

Dickinson lost his case. He took so many strikes at the plate the Court did not believe him when he said that he made a loan with the expectation of being repaid. The Court simply had to point out that, whatever Dickinson meant to do, the transaction was so removed from the routine trappings of a business loan that the Court had to assume it was something else.

Is there a lesson here? If you want the IRS to buy-in to a business bad debt deduction, you must follow at least some standard business practices in making the loan.

Otherwise it’s not business.

Pushing Accounting Methods Too Far

Way back when, when I was attending a one-room tax schoolhouse, some of the earliest tax principles we learned was that of accounting methods and accounting periods. An accounting method is the repetitious recording of the same underlying transaction – recording straight-line depreciation on equipment purchases, for example. An accounting period is a repetitious year-end. For example, almost all individual taxpayers in the U.S. use a December 31 year-end, so we say they use a calendar accounting period.

Introduce related companies, mix and match accounting methods and periods and magical things can happen.  Accountants have played this game since the establishment of the tax Code, and the IRS has been pretty good at catching most of the shenanigans.

Let’s talk about one.

Two brothers own two companies, India Music (IM) and Houston-Rakhee Imports (HRI). Mind you, one company does not own the other. Rather the same two people own two separate companies. We call this type of relationship as a brother-sister (as opposed to a parent-subsidiary, where one company owns another). IM sold sheet music. It used the accrual method of accounting, which meant it recorded revenues when a sale occurred, even if there was a delay in receiving payment. It bought its sheet music from its brother-sister HRI. Under accrual accounting, it recorded a cost of sale for the sheet music to HRI, whether it had paid HRI or not.

Let’s flip the coin and look at HRI. It used the cash basis of accounting, which meant it recorded sales only when it received cash, and it recorded cost of sales only when it paid cash. It is the opposite accounting from IM.

Both companies are S corporations, which means that their taxable income lands on the personal tax return of their (two) owners. The owners then commingle the business income with their other personal income and pay income taxes on the sum.

From 1998 to 2003 IM accrued a payable to HRI of over $870,000. This meant that its owners got to reduce their passthrough business income by the same $870,000.

But….

Remember that the other side to this is HRI, which would in turn have received $870,000 in income. That of course would completely offset the deduction to IM. There would be no tax “bang” there.

What to do, what to do?

Eureka! The two brothers decided NOT to pay HRI. That way HRI did not receive cash, which meant it did not have income. Brilliant!

The IRS thought of this accounting trick back when the tax Code was in preschool. Here is code Section 267:

             (a) In general

(1) Deduction for losses disallowed

No deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection (b). The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation.

(2) Matching of deduction and payee income item in the case of expenses and interest

If—

(A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

(B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b),  then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph). For purposes of this paragraph, in the case of a personal service corporation (within the meaning of section 441 (i)(2)), such corporation and any employee-owner (within the meaning of section 269A (b)(2), as modified by section 441 (i)(2)) shall be treated as persons specified in subsection (b).

What the Code does is delay the deduction until the related party recognizes the income. It is an elegant solution from a simpler time.

Our two brothers were audited for 2004, and the IRS immediately brought Section 267 to their attention. The IRS disallowed that $870,000 deduction to IM, and it now wanted $295 thousand in taxes and $59 thousand in penalties.

The brothers said “No way.” Some of those tax years were closed under the statute of limitations. “You cannot come back against us after three years,” they said.

What do you think? Do the brothers have a winning argument?

Let me add one more thing. To a tax practitioner, there are a couple of ways to increase income in a tax audit:

(1)  An adjustment

This is a one-off. You deducted your vacation and should not have. The IRS adds it back to income. There is no concurrent issue of repetition: that is, no  issue of an accounting method.

(2)  An accounting method change

There is something repetitious going on, and the IRS wants to change your accounting method for all of it.

The deadly thing about an accounting method change is that the IRS can force all of it on you in that audit year. In our case, the IRS forced IM to give back all of its $870,000 for 2004. It did not matter that the $870,000 had accreted pell mell since 1998.

With that sidebar, do you now think the brothers have a winning argument?

You can pretty much guess that the brothers were arguing that the IRS adjustment was a category (1): a one-off. The IRS of course argued that it was category (2): an accounting method change.

The case went to the Tax Court and then to the Fifth Circuit. The brothers were determined. They were also wrong. The brothers advanced some unconvincing technical arguments that the Court had little difficulty dismissing . The Court decided this was in fact an accounting method change. The IRS could make the catch-up adjustment. The brother owed big dollars in tax, as well as penalties.

The case was Bosamia v Commissioner, by the way.

My thoughts?

The brothers never had a chance .  Almost any tax practitioner could have predicted this outcome, especially since Section 267 has a long history and is relatively well known. This is not an obscure Code section.

The question I have is how the brothers found a tax practitioner who would sign off on the tax returns. The IRS can bring a CPA up on charges (within the IRS, mind you, not in court) for unprofessional conduct. The IRS could then suspend – or bar – that CPA from practice before the IRS. To a tax CPA – such as me – that is tantamount to a career death sentence. I would never have signed those tax returns. It would have been out of the question.

Social Security Disability Payments and IRS Penalties

I have been thinking about IRS penalties.  I had a client that racked up payroll tax penalties, and we tried to get them waived. The IRS thought otherwise. Many tax practitioners will tell you that penalty abatement rests as much on drawing a sympathetic IRS officer as any technical argument the practitioner can offer. I am increasingly a member of that camp.

Let’s briefly discuss my client, and then let’s discuss the Arthur and Cheryl English Tax Court decision.

I acquired a new client from a sole practitioner. He had been their accountant for a number of years, and it was his usual routine to go out, review the books, prepare a payables listing, run payroll and whatnot. Fairly routine stuff. The client then bought a business. In addition to more complicated accounting, the accountant now had some additional payroll tax issues to address.

It did not go well. The accountant miscalculated certain third-quarter payroll tax deposits. Others he simply deposited late. He continued this into the fourth quarter. The client sensed something was wrong, and then decided something was in fact wrong. This took time, of course. By the time my client hired me, the prior accountant had affected two tax quarters.

The IRS –of course – came back quickly with penalties.

I disagreed with the penalties. My client – relying on a tax professional – paid as and when instructed. Granted, my client eventually realized that something was amiss, but surely there is permitted a reasonable period to investigate and replace a tax advisor. Payroll can have semiweekly tax deposit requirements, which timeframe may be among the most compressed in the tax Code. It does not mesh at all with replacing a nonperforming professional.

We got the third quarter penalties waived.

Then the IRS came after quarter four. I once again trotted out my reasonable cause request. The IRS denied abatement, in response to which we requested an Appeals hearing.  My heart sank a bit to learn that our case went before a newly minted Appeals officer. She could not understand why the client had not “resolved” the payroll issue by the end of quarter three. Surely, she insisted, my client “must have known” that there was a problem, and he should have done an “investigation” or something along those lines. She trotted out the well-worn trope that is the bane to many a reasonable cause request: a taxpayer is not allowed to “delegate” his tax responsibility to another, even if that other is a tax professional.

At what point does reliance on a tax professional extend to “delegation” of responsibilities? Apparently, my scale was quite different from that of this brand-new Appeals officer.

We lost the appeal.

Sigh. I suspect that – in about ten years – she would decide the same case differently.

Let’s talk about Cheryl English.

Cheryl became disabled in 2007. She carried a private disability policy with Hartford Insurance, and Hartford paid while she filed and waited on her social security disability claim. There was a catch, however. If Cheryl were successful in receiving social security, her Hartford benefits would be reduced by any social security benefits she received.

In 2010 she won her social security claim. She received a check of approximately $49,000, from which she forwarded approximately $48,000 to Hartford. She netted approximately $1,500 when the dust cleared.

And there is a nasty tax trap here.

If one purchases a private disability policy and pays for it on an after-tax basis, then any benefits received on the policy are tax-free. It is one of the reasons that many tax advisors – including me – frown on using a cafeteria plan to purchase disability coverage.

Cheryl received tax-free benefits from Hartford.

Then she received social security.

She consulted with two CPAs. Both assured her that – since the social security was being used to repay nontaxable benefits – it would be nontaxable.

There is symmetry to their answer.

However, taxes are not necessarily symmetrical. The Code states what is taxable. Both CPAs were wrong.

Social security can be taxable. The same is true for social security disability.

The IRS wanted tax of approximately $10,500. They also wanted an “accuracy” penalty of approximately $2,100.

OBSERVATION: Remember that Cheryl only cleared approximately $1,500 from the transaction. The IRS wanted approximately $12,600 in taxes and penalties. There clearly is lunacy here.

Cheryl took the case pro se to the Tax Court. 

            NOTE: “Pro se” means she represented herself.

The Court reviewed the Code, where it found that social security benefits could be nontaxable if one repays the benefits. That is not what happened here, however. Cheryl received social security benefits but repaid an insurance company, not the Social Security Administration. The Court looked for other exceptions, but finding none it determined that the benefits were taxable.

She owed the tax.

The Court struck down the “accuracy” penalty, though, observing that she sought the opinion of two CPAs and acted with reasonable cause and in good faith. The Court commented on the complexity of the tax law in this area, stating:

The disparate treatment of private and public disability benefits for tax purposes is curious and somewhat confusing,”

I am curious why Cheryl made no claim-of-right argument. There is a provision in the Code for (some) tax relief when a taxpayer recognizes something as income and later has to pay it back. I presume the reason is that Cheryl did not have tax (or much tax) in the Hartford years, so the tax break would have been zero or close to it when she repaid Hartford.        

Cheryl won on the penalty front, but she still had to pay taxes of $10,500 on approximately $1,500 of net benefits. Frankly, she may have been better off not having the Hartford policy in the first place.