The recent news of the Kinder Morgan reorganization brings one of the most tax efficient investment vehicles, master limited partnerships (MLP), to the forefront. We will briefly describe what an MLP is, simplistically explain how it works, identify who are good candidates to own them, and highlight how the Kinder Morgan reorganization may disrupt certain tax strategies.

This is not meant to opine on the benefit of the Kinder Morgan transaction, but to point out certain tax consequences and potential strategies.

What is an MLP?

An MLP is a publicly traded partnership. The investor buys units in an MLP, which makes them a partner in the MLP. Partnership taxation makes this investment an extremely tax-advantaged vehicle in that the investor is buying units in a pass-through, or flow-through, entity. Income taxes are not paid at the MLP level, but items that calculate the tax are passed through to the unitholders.

How does an MLP Work?

The investor receives quarterly cash distributions that are based on distributable cash flow. These payments are not dividends as we would think of them. The distributable cash flow starts with net income, then adds depreciation charges, and then subtracts reserves and other items. Most MLP’s distribute most of their distributable cash flow. Due to the large depreciation charges, the investor receives tremendous tax deferred distributions. Up to 80-90% of the distributions are tax deferred. Remember tax deferred is not tax free. In an MLP these tax deferred distributions are referred to as a return of capital.

The unitholder needs to keep track of his or her basis in each unit purchased. Simplistically, net income increases the basis, and distributions lower the basis. It is likely the basis will decrease each year. When the basis gets to zero, the return of capital is taxed at capital gains rates. As you can see the longer the unitholder holds the MLP, the higher the depreciation charges or return of capital. This tax deferral is absolutely amazing until the unitholder sells his or her units or, in the Kinder Morgan case, reorganization of the MLP occurs. Then, the tax man cometh.

There are passive loss rules that are indigenous to MLP’s. If an MLP has a loss, it is characterized as a passive loss that can only be deducted from income from the same MLP. The loss may be carried forward until that MLP has sufficient income to use the loss carry forward. Net income from an MLP is treated as non-passive income. Make sense yet?

Who is a Good Candidate for an MLP?

Let’s consider who would be good candidates for investment in an MLP. Obviously investors who want excellent tax deferred yields are an important target. However, more important are older folks like me who incorporate MLP’s for Estate Planning purposes. The investor receives excellent tax deferred returns and at death their heirs receive a step up in basis and the previously tax deferred distributions become tax free. Forget the word deferred. You pay no tax on the tax deferral. Beautiful, until the units are sold or the MLP is reorganized. Then the estate plan is not only scrapped, but the tax man cometh.

Remember the adjusted basis of the units. When the units are sold or reorganized, the difference between their adjusted basis and the consideration received will be taxed at two different rates. First, the tax deferral on return of capital is taxed at ordinary tax rates. You have to recapture the depreciation previously taken. The remaining gain is taxed at capital gains rates. With these basic facts concerning MLP’s, let’s review the Kinder Morgan reorganization.

Kinder Morgan Reorganization

On August 10, Kinder Morgan, Inc. (KMI), announced plans to acquire oil and gas pipeline partnerships Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB), as well as Kinder Morgan Management (KMR), in a $44 billion transaction. For stockholders of KMR, a holding company, the transaction will be tax free. However, for unitholders of KMP and EPB, the transaction will be taxable. The company estimates that the average investor of KMP will owe taxes ranging from $12.39 to $18.16 per unit depending on the investor’s tax rate. The impact might be higher based upon how long the units have been held and the total tax deferred as part of the total consideration. The company expects to distribute $10.77 of cash per unit of KMP. As you can see, the “average” investor will not cover taxes with the cash boot; the unitholder will pay ordinary tax rates on the depreciation recaptured (up to 39.6%) and capital gains on the remainder (up to 20%). This does not count the net investment tax of 3.8%.

My recommendation would be for all unitholders of KMP and EPB to consult their tax advisors as soon as possible. Unitholders lost a lawsuit to force a super majority vote last week. The vote is currently scheduled for November 20 with the transaction to be consummated by the end of the month.

By consulting with tax advisers by December 31st, unitholders have time to mitigate the effect of their tax liability. Most substantive tax planning strategies have to be consummated by December 31. These include, but are not limited to, investments in oil and natural gas drilling partnerships, conservation easements and captive insurance companies. Please see your tax adviser, quantify the tax due, and then pick a planning strategy that is right for you.