With the passage of the tax reform act (formerly known as the Tax Cuts and Jobs Act or the "Act") by Congress this week and the expectation that President Trump will sign it into law, many changes to the Internal Revenue Code (the Code) impacting Master Limited Partnerships (MLPs) and their unitholders will now go into effect.
We plan to discuss the changes affecting MLPs in detail in a webinar that is scheduled for January 11. In the meantime, the discussion below provides a high-level summary.
MLP Tax Rate vs. Corporate Tax Rate
A significant benefit of MLPs over C corporations is the lower effective tax rate that applies to MLP income. The Act preserves that benefit through 2025.
New Effective C Corporation Tax Rate
The Act permanently reduces the corporate tax rate to a flat 21%, beginning in 2018. When combined with the maximum 20% tax rate on qualified dividends paid by a C corporation to an individual shareholder, the effective tax rate on income of a C corporation distributed to its shareholders will be 36.8% (or 39.8% after the 3.8% Medicare tax on dividends).
New Effective MLP Tax Rate
The Act reduces the maximum individual tax rate to 37%, beginning in 2018. In addition, the Act provides a deduction to individual MLP unitholders generally equal to 20% of the MLP’s domestic income and 20% of any recapture income of an MLP unitholder on the sale of an MLP unit. The wage-based limitation on the 20% deduction that applies to other pass-through entities does not apply to MLPs or REITS. The combination of the reduced individual tax rate and the 20% deduction lowers the effective tax rate on income of an MLP to 29.6% (or 33.4% after the 3.8% Medicare tax). Both the reduced 37% tax rate and the 20% deduction sunset after 2025.
Table of Effective Tax Rates Before and After the Act
Sunset of Lower MLP Effective Tax Rate
The reduced maximum individual 37% rate and the 20% deduction for MLP income, but not the reduced 21% rate on income of a C corporation, are scheduled to expire after 2025. Thus, after 2025, the effective tax rate on MLP income will be slightly higher than the effective tax rate on C corporation income (39.6% for MLPs and 36.8% for C corporations, in both cases before the 3.8% Medicare tax), unless the individual reduced rates and the 20% deduction are extended before then. Because many other favorable provisions of the Act sunset after 2025, it is possible that future legislation will extend the MLP effective tax rate benefit beyond 2025.
Interest Deduction Limitation
The Act imposes a new limitation on interest expense deductions of large business taxpayers, including MLPs, beginning in 2018. The Act limits net interest expense deductions of an affected entity to 30% of its "adjusted taxable income." "Adjusted taxable income" is taxable income computed without regard to
- business interest expense,
- business interest income,
- the 20% deduction for pass-through entities,
- net operating losses, and
- for taxable years prior to 2022, depreciation, amortization, and depletion.
The limitation is calculated and applied separately for each entity, in a manner that is intended to avoid double-counting. For example, in calculating the limitation on an MLP’s ability to deduct its own interest expense, the MLP would take into account net income allocated to it from a subsidiary partnership only if the subsidiary partnership’s interest expense fell short of 30% of the subsidiary partnership’s adjusted taxable income, and in proportion to that shortfall. Similarly, an MLP unitholder would take into account net income allocated to it from the MLP in calculating the limitation on the unitholder's interest expense only if the MLP's interest expense fell short of 30% of the MLP's adjusted taxable income, and in proportion to that shortfall.
Disallowed interest expense allocated to an MLP unitholder can be carried forward indefinitely, to a year in which the unitholder's share of the MLP's interest expense does not exceed 30% of the unitholder's share of the MLP's adjusted taxable income. The disallowed interest expense immediately reduces the unitholder’s basis in its MLP interest, but any amounts that remain unused upon disposition of the interest are restored to basis immediately prior to disposition.
Under the Act, the bonus depreciation percentage is generally increased to 100% (from its current level of 50%) for property placed in service after September 27, 2017 and before 2023. After 2022, the bonus depreciation percentage is phased-down to 80% for property placed in service in 2023, 60% for property placed in service in 2024, 40% for property placed in service in 2025, and 20% for property placed in service in 2026.
The Act expands the availability of bonus depreciation to non-original use property, as long as it is the taxpayer's first use. The Act does not provide any express rules for how this expanded availability applies to purchasers of MLP units or other partnership interests. Bonus depreciation is not available for property of a regulated public utility.
The Act permanently repeals the partnership technical termination rule contained in Section 708(b)(1)(B) of the Code, effective in 2018. This repeal allows an MLP or other partnership to continue-without resetting depreciation periods and without allowing or requiring new elections-even after the disposition by partners of more than half of the partnership's outstanding capital and profits interests in a twelve-month period.
Sale of Foreign Partner' Partnership Interest
Under the Act, gain or loss realized by a foreign corporation or a foreign individual from the sale or exchange of an interest in a partnership engaged in a U.S. trade or business is treated as effectively connected with a U.S. trade or business to the extent that the sale of all the partnership assets would have produced effectively connected gain or loss. This provision applies to sales, exchanges, and dispositions occurring on or after November 27, 2017. This provision repeals the result in Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (2017), where the Tax Court held that a foreign partner was not subject to U.S. tax on sale of a partnership interest, rejecting the holding of Rev. Rul. 91-32 to the contrary.
The transferee of a partnership interest is required to withhold 10% of the amount realized by the transferor unless the transferor certifies that it is not a foreign person. The partnership is required to deduct and withhold from the transferee amounts that should have been withheld by transferee. The explanation to the Act indicates that the IRS may under regulatory authority granted to it provide guidance permitting brokers to handle the withholding of the 10% tax in cases where foreign partners sell MLP units through a broker. The withholding requirement is effective for sales, exchanges, and dispositions after December 31, 2017.