H.R.1, known as the Tax Cuts and Jobs Act or the “Tax Act,” was signed into law on December 22, 2017. Notably, while this much anticipated tax reform legislation contains a number of provisions of interest to the MLP community and our energy clients, the Tax Act preserves the “qualifying income exception” under the Internal Revenue Code that allows certain MLPs to be treated as partnerships for federal income tax purposes. Thus, MLPs retain their tax-advantaged status, and income earned by an MLP will continue to be passed through to its owners without being subject to an entity-level federal income tax.
Highlights for MLPs and Energy Clients
Individual Tax Rates and Pass-Through Deduction. Individual investors in traditional energy MLPs will benefit from a reduction in federal income taxes for taxable years through December 31, 2025.
The Tax Act drops the top marginal tax rate for individuals from 39.6% to 37% and provides traditional energy MLP owners a 20% deduction attributable to their allocable share of domestic business income of the MLP. Both the reduction in tax rates for individuals and the 20% deduction for pass through business income “sunset” for taxable years beginning after December 31, 2025 when individual rates are scheduled to revert to 2017 rates.
The “pass-through deduction” provisions provide that non-corporate owners of pass-through entities may take a deduction for certain pass-through income equal to (i) 20% of their domestic “qualified business income” plus (ii) 20% of any qualified dividends from real estate investment trusts (i.e., those that are not capital gains dividends or otherwise constitute qualified dividend income), a taxpayer’s allocable share of qualified income from a publicly traded partnership, and gain recognized upon the sale of an interest in such partnership that would otherwise be taxed as ordinary income.
For this purpose, “qualified business income” is defined as all domestic business income other than investment income (e.g., dividends, income equivalent to a dividend, interest income not allocable to a trade or business, short- and long-term capital gains, etc.). Once specific income thresholds are met ($315,000 for joint filers), the deduction for qualified business income is limited to the greater of (i) 50% of the W-2 wages paid by the business and (ii) 25% of the W-2 wages paid by the business plus 2.5% of the cost of tangible depreciable assets in the business. The tangible depreciable asset component of the W-2 wage limitation was a late add that potentially expands the 20% deduction to businesses that do not have many employees (e.g., partnerships in which all service providers are partners) or that are capital-intensive (e.g., real estate firms).
Individuals that derive income from personal service businesses (e.g., accountants, lawyers, consultants, financial service providers, those in the performing arts, and those investing, trading or dealing in securities, but excluding engineering and architecture services) are not entitled to the deduction unless the owner’s income is less than threshold amounts ($415,000 for joint filers) and the benefit of the qualified business deduction is phased out for amounts exceeding specific income thresholds ($317,000 for joint filers).
Reduced Corporate Tax Rates. The Tax Act reduces the corporate tax rate to a flat 21% (down from a maximum of 35% currently) with no sunset of the rate reduction. After taking into account the tax on qualified dividends and the net investment income tax of 3.8%, the effective tax rate on individual income earned through corporations is now roughly 39.8%.
Immediate Expensing. The Tax Act temporarily provides bonus depreciation to allow taxpayers to fully and immediately expense the full cost of “qualified property” acquired and placed in service after September 27, 2017 and before January 1, 2023. Qualified property is new or used property generally subject to the allowance for depreciation. However, immediate expensing does not apply to certain regulated utilities businesses, including the transportation of gas by regulated pipeline.
Limitation on Business Interest Expense Deductions. The Tax Act effectively limits the deduction for business interest to the amount of “business interest income” plus 30% of adjusted taxable income. The definition of adjusted taxable income under the Tax Act does not deduct depreciation and amortization (i.e. EBITDA rather than EBIT) for taxable years beginning before January 1, 2022. After December 31, 2021, adjusted taxable income for purposes of the 30% limitation will be reduced by depreciation and amortization. The limitation generally does not apply to small businesses with average annual gross receipts for the three-taxable-year period ending with the prior taxable year that do not exceed $25 million. Disallowed business interest is treated as paid or accrued in the succeeding taxable year and can be carried forward indefinitely.
For a partnership, the limitation applies at the partnership level and partners are required to determine their adjusted taxable income limitation without regard to the partner’s distributive share of all partnership items. The pass-through to partners is designed to prevent double counting but nonetheless allow a partner to deduct additional interest expense the partner may have paid or incurred to the extent the partnership could have deducted more business interest.
Tax and Withholding on Nonresident’s Sale of Partnership Interest. For sales or exchanges occurring on or after November 27, 2017, gain recognized by a nonresident on the sale of an interest in a partnership that is engaged in a U.S. trade or business will be treated as effectively connected income and subject to U.S. federal income tax.
The Tax Act also provides a new withholding provision effective for sales or exchanges of partnership interests occurring after December 31, 2017. In general, if any portion of the gain on any disposition of an interest in a partnership would be treated as effectively connected with the conduct of a trade or business within the United States, then the transferee must withhold a tax equal to 10% of the “amount realized” on the disposition unless the transferor certifies, among other things, that it is not a foreign person. The legislation further provides that in the event the transferee of such partnership interest fails to withhold, the partnership is responsible for the withholding tax. The Tax Act authorizes the Treasury Department to issue such regulations or other guidance as may be necessary to carry out the purposes of the new withholding provisions, including regulations providing for exceptions and regulations providing for the application of withholding in the case of publicly traded partnerships.
Recognizing that these Tax Act withholding provisions present significant practical problems, the Treasury Department and the IRS have determined in Notice 2018-08 that withholding under the new statute should not be required with respect to any disposition of an interest in an MLP until regulations or other guidance have been issued. The temporary suspension is limited to dispositions of interests that are publicly traded and does not extend to non-publicly traded interests. The Treasury Department and the IRS intend to issue future regulations or other guidance on how to withhold, deposit, and report the tax withheld with respect to a disposition of an interest in a publicly traded partnership. Future guidance with respect to a disposition of an interest in a publicly traded partnership will be prospective and will include transition rules to allow sufficient time to prepare systems and processes for compliance.
Repeal of Technical Terminations. The Tax Act permanently repeals the partnership technical termination rule such that MLPs will no longer have to track public trading of their interests to determine whether a technical termination has occurred. The partnership technical termination rules had required all partnerships, including MLPs, to restart depreciation periods and make new tax elections to the extent sales or exchanges of their interests totaled 50% or more of the partnership’s capital and profits interests in a twelve month period.
Carried Interests. Prior to the Tax Act, a taxpayer who owned an interest in a partnership that recognizes long-term capital gain would include in income the taxpayer’s allocable share of that long-term capital gain. Under the Tax Act, if a non-corporate taxpayer owns a partnership interest received in connection with the performance of services in an “applicable trade or business,” any capital gain allocable to such taxpayer in respect of assets held by the partnership for more than one year that would have otherwise been treated as long-term capital gain will be converted into short-term capital gain unless the assets are held by the partnership for more than three years. Although it is not entirely clear, the legislative history indicates that the holding period for these purposes is determined at the partnership level. Accordingly, a taxpayer holding a carried interest may be able to obtain long-term capital gain treatment even if the taxpayer has held the partnership interest for three years or less. An “applicable trade or business” means the business of raising or returning capital or investing in or developing specified assets. Specified assets consist of securities, commodities, real estate held for rental or investment, related derivatives, and partnership interests to the extent of the partnership’s interest in these assets.
Taxation of Natural Resources. The taxation of natural resource related expenditures generally remains unchanged under the Tax Act, including the deductions for intangible drilling costs and depletion. The Tax Act does, however, repeal the Section 199 deduction for domestic production activities.
Repeal of the Corporate Alternative Minimum Tax. The Tax Act repeals the corporate alternative minimum tax, allows a corporation with AMT credit carryforwards to claim a refund of 50% of the remaining credits through 2020, and allows a potential refund of all remaining credits beginning in 2021.