Today, the IRS released anxiously awaited proposed regulations defining qualifying income for publicly traded partnerships, usually referred to as “master limited partnerships” (MLPs). These rules are critical to more than 150 publicly traded businesses because 90 percent or more of the entity’s gross income must be from qualifying income for a publicly traded entity to be taxed as a partnership rather than a corporation.

Although Internal Revenue Code section 7704 generally defines qualifying income, there has never been a set of detailed regulations to determine what constitutes qualifying income. In the absence of such regulations, taxpayers have relied heavily on the IRS private letter ruling (PLR) process to confirm that specific sources of revenue would qualify. In March 2014, the IRS announced a temporary halt or “pause” on these PLRs because there had been a high volume of ruling requests in new, very fact-specific areas, such as oilfield services related to fracking. In addition, the IRS wanted to develop regulations that would guide and support its determinations on PLR requests. Although originally expected to be a two- to three-month pause, the review stretched to longer than a year while the Treasury Department evaluated where and how to draw the line that defined qualifying income. Today’s proposed regulations represent the culmination of that project.

The IRS and Treasury have been clear that their goal was to produce regulations that reach the same conclusions that they reached under previously issued PLRs, although there inevitably will be some points in the regulations that may produce a different outcome. However, to the extent that the regulations reach a different result, the regulations offer a 10-year transition period.

The broad topic of the regulations is whether income from activities with respect to minerals or natural resources, such as oil and gas, is qualifying income. The activities addressed include exploration, development, mining or production, processing, refining, transportation (including pipelines) and marketing of any natural resource (including fertilizer, geothermal energy and timber). The drafters’ intent was to qualify income only from activities undertaken by exploration and production companies, refineries, pipelines and marketers of mineral or natural resources, and not income from the activities of service providers to those businesses.

The regulations do, however, include an analysis under which a non-oil and gas service provider’s activities could be considered so intrinsic to the activity of the producer or refinery that they also generate qualifying income. To be considered “intrinsic,” the regulations provide that the activities must be specialized to the business, be essential to the completion of the activity and require the provision of significant services to support the activity. For example, catering services could not be considered specialized to the production of oil and gas, so income from the provision of catering services to workers at a drilling site would not be qualifying income. Although the mere sale of goods to a driller (such as the sale of water to support fracking operations) does not produce qualifying income, if the transaction includes the provision of services such as removal, cleaning and recycling (as occurs in a saltwater disposal business), then the activity is considered intrinsic and would generate qualifying income.

Another key aspect of the rules is the extent to which income from products processed from natural resources would qualify, such as paper processed from timber and chemicals processed from oil and gas. In general, the proposed rules bless products that are byproducts of natural resource processing but exclude products derived by adding or mixing other substances into the product. Thus, sales of paper would not generate qualifying income. The question of whether processing ethane into ethylene generates qualifying income was closely watched. The new proposed regulations favor vertical integration by providing that byproducts such as ethylene from the physical and chemical separation of crude oil in the course of producing gas or fuel can create qualifying income, whereas the manufacture of ethylene directly from ethane would not.