Senate Energy and Natural Resources Committee Chairman Lisa Murkowski shakes hands with President Donald Trump on the White House lawn Dec. 20 after the tax bill passed.
Source: Associated Press
Even with a slash to the corporate rate, master limited partnerships maintain a tax advantage for energy investors, in part due to a new deduction under the Republican tax plan that passed through Congress on Dec. 20.
"On a relative basis, C-corps will become incrementally more attractive owing to tax code changes, but MLPs continue to hold a tax advantage," analysts at CreditSights wrote in a Dec. 21 note to clients. "C-corp tax rates will be lowered to 21% from 35%, while the dividend rate is unchanged at 20%, resulting in a 22% improvement in total tax rates, while MLPs will be able to take a 20% deduction on taxable income and have slightly improved individual rates. At the top individual rates, this results in a 17% improvement for MLPs."
The bill, expected to be signed by President Donald Trump, lowers the top individual rate from 39.6% to 37%. Combined with the 20% pass-through deduction, which applies to both business income and MLP unit sales, this means MLP investors could see their tax liabilities drop substantially. Under the existing tax code, a shareholder with $100 in net income from MLP investments would pay up to $39.60 in taxes. But with the 20% deduction, an investor's tax basis would be reduced to $80, 37% of which is $29.60.
MLPs, which pass earnings and taxes through to individual unit holders, emerged in the 1980s as a popular investment vehicle for generating stable and steady returns from steady-flowing assets like oil and gas pipelines. The Tax Reform Act of 1986 ensured that MLPs would continue to be taxed as partnerships, but the Revenue Act of 1987 defined which businesses qualified as MLPs, restricting them to entities receiving 90% of gross income from qualifying sources, including upstream and midstream natural resources.
The Republican tax plan represents the biggest change to MLP taxation since that qualifying income rule. Height Securities LLC analyst Katie Bays said she was surprised by the extent to which Congress decided to change the playing field for midstream partnerships.
"Certainly, we expected that the MLP structure would remain intact," she said in an interview. "I think it was a bit of a surprise to see the Senate and the House both pursue some kind of a change to the pass-through logic so ferociously … and to make sure that the pass-through language was conferred upon MLPs, as well."
Getting to the 20% deduction, however, required a compromise that favored the Senate's approach to taxing MLPs. The House version of the tax bill capped pass-through income tax rates at 25%, while the Senate's original version provided for a 17.4% deduction. The amended Senate bill increased the deduction for pass-through businesses to 23% and also exempted MLPs from a wage limitation that would have excluded them from that benefit. The final bill includes that exemption.
Another key difference between the two bills was how they treated active and passive investors. The Senate version used the same tax deduction rate for both groups, but the House version applied a higher rate to active investors, which typically include management, than in the Senate bill. The reconciled bill does not separate the two types of investors.
Even though the 20% deduction only lasts through 2025 under the final bill, Gibson Dunn & Crutcher LLP tax attorney James Chenoweth said he was optimistic that Congress will make the deduction permanent through future legislation.
"There's a lot of political incentive to do that," he said in an interview.
In the meantime, CreditSights analysts do not expect MLPs to all suddenly convert their business structures to take advantage of corporations' bigger tax benefit relative to partnerships.
"Management teams will need to decide whether the overall tax advantage and benefits of tax deferral outweigh the increased liquidity provided by c-corps having a much larger institutional investor base," they wrote. "The institutional investor base has been increasing for MLPs anyway, which could offset the slightly reduced tax advantage the MLP structure provides."
Still, MLPs are using mergers with parent companies to simplify capital structures as they continue to recover from the 2014 commodity price downturn. Midstream heavyweights such as Kinder Morgan Inc., Targa Resources Corp. and ONEOK Inc. have all recently combined their general and limited partners.