MASTER LIMITED PARTNERSHIPS received a jolt in early August with news that Kinder Morgan, one of the first adopters, is abandoning the structure and moving its assets into a corporation.
At the same time, Perry Capital, a hedge fund, is encouraging International Paper and other corrugated paper and packaging companies to boost their share prices by putting some assets into MLPs.
MLPs, or master limited partnerships, are large partnerships whose units are publicly traded. No taxes are collected at the entity level. Rather, earnings are taxed directly to the partners. MLPs must receive at least 90% of their income each year from good sources. Good income includes rents from real property, interest, dividends and from “exploration, development, mining or production, processing, refining, transportation . . . or the marketing of any mineral or natural resource.” Companies organized as MLPs can raise equity at high multiples to earnings because no taxes are taken out of the earnings at the company level. Investors also pay a premium for liquidity or the ability to sell the shares on a stock exchange or in a secondary market.
Kinder Morgan plans to pay $44 billion to buy and consolidate two MLPs and put their oil and gas pipelines under a single taxable corporation known as Kinder Morgan Inc. The goal appears to be to simplify what had become too complicated an ownership structure and to realize still greater tax savings by operating in the future as a corporation.
The two MLPs are operated by a Kinder Morgan management company that is a corporation. Management companies earn larger splits or fees the more cash they can distribute each year to partners. Between 45% and 50% of the cash generated by the MLPs was passing through the management company in fees. The corporation is buying the MLPs for a mix of stock and cash. It will get a step up in asset basis and be able to depreciate the assets anew. It will also be able to use interest deductions at the corporate level as additional tax shelter.
The company expects to realize $20 billion in tax savings over the next 14 years.
The tax advantages are expected to allow it to increase its dividend per share from $1.72 to $2 next year. It said it expects dividends to increase by 10% a year through 2020. The company will pay a 15.4% premium to the MLP unit holders in the buyout.
Many, perhaps most, unit holders will end up having to pay more taxes than they will receive in cash. One analyst estimated that the average investor in the larger of the two MLPs could owe between $12.39 and $18.16 in taxes per unit while he or she is expected to receive only $10.77 in cash per unit. The analyst compared the buyout to a transfer of tax benefits from unit holders, who have been able to defer taxes on their capital gains, to Kinder Morgan Inc., which will now be able to depreciate the MLP assets anew.
Meanwhile, paper company share prices jumped in July after Perry Capital, a hedge fund, said in a second quarter letter to its investors that converting into MLPs could boost share prices by 50% to 100% across the industry.
The hedge fund said it hired PricewaterhouseCoopers to confirm that some paper company operations can be moved into MLPs, and the accounting firm said the structure works for mills that make containerboard largely from virgin logs and wood chips. The mills would have to use less than 25% recycled fiber.
The International Paper Co. CEO said in late July that conversion into an MLP is “theoretical” without an IRS ruling. He acknowledged that the company has been investigating the structure. The IRS has a hold currently on MLP rulings while it wrestles with a “hamburger stand” issue. The issue is how closely involved in exploring for or producing oil, gas and other minerals a company has to be before its income qualifies as good income. For example, the agency had been issuing favorable rulings to companies that provide various production-related services to gas companies engaged in fracking.
Companies that are thinking of spinning off assets into a REIT could also operate through an MLP since “rents from real property” are good income for an MLP. The IRS issued proposed regulations in April to bring the definition of real property for REIT purposes up to date. The Solar Energy Industries Association urged the IRS in comments on the proposed regulations in August to adopt a slightly broader definition of real property for REIT purposes, but said the same definition should not extend to master limited partnerships.