Major Corporate Rate Cut Could Alter MLP Landscape

By Stuart E. Leblang, John Goodgame, Michael J. Kliegman,  and Amy S. Elliott

President Trump has proposed reducing the tax rate on business income to 15 percent for both traditional corporations (“C corps”) and small businesses (“pass-throughs”).  House Republicans have proposed reducing the income tax on C corps to a flat rate of 20 percent, while the active business earnings of pass-throughs would be capped at a maximum rate of 25 percent.

Although there are real questions about whether such proposals—in particular, a business rate of 15 percent—are achievable, both would dramatically change the tax calculus for publicly traded partnerships (PTPs; also referred to as master limited partnerships or MLPs) and could cause them to consider giving up their single level of tax for what could be a more beneficial structure.  Consider the following:

• One would think that a pass-through rate reduction (from effectively 39.6 percent to either 15 percent or 25 percent) would increase interest in MLPs.
• This does not consider the bump in market interest that firms would likely get from a larger C-corp investor base.
• The investor base for MLPs is smaller, since tax-exempts, individual retirement accounts (IRAs) and mutual funds fear unrelated business taxable income (UBTI).
• It is this tax handicap that prevents MLPs from being included on market indexes.
• C corps can have lesser cash distribution pressures, which can offer more merger and acquisition (M&A) flexibility.
• Some founder benefits can be preserved in an MLP-to-C-corp conversion.
• A recent MLP initial public offering (IPO) contained language to ease future conversion to a C-corp structure.

MLPs are very efficient entities under today’s tax system.  As long as 90 percent of the business’s gross income is in the form of interest, dividends or rents, or is derived from a natural resource, then it does not have to pay any corporate-level tax on the income, but can flow all of it up, where it is then taxed (if at all, given the tax shield^[1]) at the investor level.  Under current law, C corps pay a top federal income tax rate of 35 percent.  C corp distributions are then taxed as shareholder dividends at a top rate of 20 percent.

Many businesses operate as MLPs.  Although they are largely in the oil and gas space (for example, Energy Transfer Equity LP (ETE); Energy Transfer Partners LP (ETP); Enterprise Products Partners LP (EPD); Plains All American Pipeline LP (PAA); and Williams Partners LP (WPZ)), there are a fair number that are in the investment fund/private equity space (for example, Apollo Global Management LLC (APO); Ares Management LP (ARES); The Blackstone Group LP (BX); The Carlyle Group LP (CG); and KKR & Co LP (KKR)).

Some analysts have been saying that a reduction in the tax rate on pass- through income would cause the income distribution from an MLP to be taxed once at 15 percent under Trump’s plan (instead of the top individual tax rate, which, under Trump’s plan, would be 35 percent), making MLPs “the most attractive investment from a tax point of view.”^[2]However, they acknowledge that, if the top corporate rate is also dramatically reduced (and a 20 percent corporate rate would likely be enough), MLPs may want to convert to C corps, since the double tax hit— albeit at lower rates—would be offset by what could be a dramatic increase in the investor base.³

If an MLP is held by a tax-exempt entity (such as a university endowment) or a tax-advantaged retirement account (such as a Roth IRA), it gives off UBTI, triggering tax to the investor.  In addition, mutual funds can have no more than 25 percent of their assets invested in MLPs.⁴(Also of note, MLPs are required to withhold on distributions to foreign unitholders.)

Because of these limitations, the Financial Times Stock Exchange (FTSE) will not include MLPs or any entity that produces UBTI in the FTSE Russell U.S. equity indexes.⁸Researchers have found that, when a stock is added to an index, its price goes up by as much as 7 percent.⁹

The C-corp structure carries other benefits.  One of the main reasons investors are drawn to MLPs is that their partnership agreements are often designed to incentivize or require the partnership to pay out significant distributions (and increase those distributions over time), even though—unlike with real estate investment trusts—there is no tax law requirement that a certain percentage of the entity’s income is passed along to the owners.  This structure, and the correlated market expectations, tends to make MLPs reliant on outside capital to finance M&A activity instead of using retained earnings, and also tends to force MLPs to focus their M&A activity on the acquisition of assets that are almost immediately accretive to cash flows.  C corps, which may have similar market expectations around dividends, do not typically have structural features that require regular payments to equity and thus may have more M&A flexibility.

Note, however, that corporations have less flexibility from a governance standpoint than MLPs, especially in the ability to contractually modify or replace fiduciary duties.  As a result, any MLP that becomes a corporation (as opposed to a limited partnership, LP, or a limited liability company, LLC, that elects to be taxed as a corporation) would likely no longer consider the so- called “drop down” approach to growth that so many sponsored oil and gas MLPs have pursued.

Owning a C corp is also simpler from an investor standpoint.  Instead of getting a Schedule K-1, investors receive a familiar Form 1099-DIV.  In addition, the administrative costs are much smaller for the business, since preparing Schedules K-1 for hundreds of thousands of unitholders is very costly.¹⁰

Changing an MLP to a C corp structure was largely unheard of before 2014, when Kinder Morgan announced that it would undertake a shareholder/unitholder vote to combine KMP into KMI, thus shedding its MLP structure and the associated IDRs (an MLP’s version of carried interest) that were causing KMP to pay out most of its cash distributions to KMI as opposed to KMP’s public unitholders.¹¹

As was the case with Kinder Morgan, a growing portion of MLP income is already subject to two levels of tax.  C corps are often already integrated into the larger MLP structure, serving as blockers.  This is particularly the case as more funds get into the business of making direct loans, which can present tax risks if not isolated in a blocker corporation.  Blockers also can be used in oil and gas MLPs where the entity owns associated businesses that do not generate qualifying income under the MLP tax rules but that are important to the entity’s overall operations.¹²

MLP-to-C-corp conversions can be structured in various ways, some of which cause more disruption to unitholders than others.  A roll up is generally effected by way of a reverse triangular merger, triggering tax to the unitholders, who also lose the tax shield that they enjoyed as a result of getting allocated items of depreciation or depletion along with the MLP’s income.¹³A conversion could come about by the partnership filing a C-corp return instead of a partnership return, declining to avail itself of the qualifying income exception (or by affirmatively electing to be taxed as a corporation).  In that case, any exchange right benefits and stepped-up basis payments afforded to founders and insiders under a tax receivable agreement are preserved.

Anticipation that tax reform will create a large gap between the top corporate rate and the top individual rate—along with a few recent IPOs involving so-called Up-C structures following Kinder Morgan’s conversion—may have been one reason why Hess Midstream Partners LP (HESM) built a tax exit strategy into its IPO documents.  In its prospectus filed April 6, 2017, Hess pointed out that it included a provision in its partnership agreement for its general partner (GP) to “without unitholder approval, cause the Partnership to be treated as an entity taxable as a corporation.” The GP can effect the change “by our election or conversion or by any other means or methods,” and the change must be made “in connection with the enactment of U.S. federal income tax legislation or a change in the official interpretation of existing U.S. federal income tax legislation by a governmental authority.”¹⁴

Such a provision is not entirely new.  Investment funds Ares,¹⁵Blackstone,¹⁶Carlyle^[17]and KKR¹⁸all give their GPs the ability to elect that the partnership be treated as a corporation if “it is no longer in our best interests to continue as a partnership for U.S. federal income tax purposes,” although there is no mention of a change in the tax laws.  The language can be found as far back as December 2006, when it showed up in the Form S-1/A of Fortress Investment Group Holdings LLC (FIG).¹⁹

This is the opposite of what can be found in the partnership agreements of most oil and gas MLPs, which generally have numerous provisions designed to ensure that no actions will be taken to cause the MLP to be treated as a corporation for federal income tax purposes.  Accordingly, for most oil and gas MLPs, approval of their unitholders would be required before the MLP could make an election to change its tax status.

Choice-of-entity decisions will clearly be affected by tax reform that dramatically changes the rates on corporations and individuals, especially if it increases the differential between the two rates.  There are many factors to consider when deciding whether a C corp, an MLP or a hybrid structure like an Up-C makes the most sense.

^{[1] Assuming a unitholder has sufficient basis, distributions made by MLPs are generally nontaxable return of capital.}

^{[2] Elliott, Amy S., August 12, 2014, “Kinder Morgan Consolidates, Converting 2 PTP Pipeline Operators,” Tax Notes, Doc 2014- 20009.}

^{[3] A number of MLPs have also converted to C corps in the context of bankruptcy restructuring, including Atlas Resource Partners LP (ARP), which became Titan Energy LLC, and LINN Energy LLC (LINE), which became LINN Energy Inc.}

^{[4] https://www.sec.gov/Archives/edgar/data/1603145/000119312514253742/d696235d424b4.htm.}

^{[5] Campos, Rodrigo and Liz Hampton, April 26, 2017, “Trump’s tax cut proposal shines light on MLPs,” Reuters (http://www.reuters.com/article/us-usa-tax-mlps-idUSKBN17S2KS?il=0 ), quoting Robert Willens of Robert Willens LLC.}

^{[6] Kim, Crystal, April 17, 2017, “What if U.S. Alt Asset Managers Converted to C-Corps?” Barron’s (http://www.barrons.com/articles/what-if-u-s-alt-asset-mangers-converted-to-c-corps-1492455414?tesla=y) and Andrew Bary, December 17, 2016, “Advice From Wall Street’s Go-To Tax Man,” Barron’s (http://www.barrons.com/articles/advice-from-wall- streets-go-to-tax-man-1481956046 ) .}

^{[7] https://www.mlpassociation.org/wp-content/uploads/2015/08/102205Faqs.doc.}

^{[8] April 2017, Russell U.S. Equity Indexes v2.5 (http://www.ftse.com/products/downloads/Russell-US-indexes.pdf), pages 15-16.}

^{[9] Chang, Yen-cheng, Harrison Hong and Inessa Liskovich, August 2013, “Regression Discontinuity and the Price Effects of Stock Market Indexing” National Bureau of Economic Research (http://www.nber.org/papers/w19290.pdf).}

^{[10] Elliott, Amy S., November 19, 2014, “Kinder Welcomes Shedding of Its ‘High-Maintenance’ MLP Structure,” Tax Notes, Doc 2014-27424.}

^{[11] Gelles, David, August 11, 2014, “Kinder Morgan’s Reorganization Puts Master Limited Partnerships in Question,” The New York Times (https://dealbook.nytimes.com/2014/08/11/kinder-morgans-reorganization-puts-master-limited-partnerships-in- question/).}

^{[12] Mooney, Attracta, December 12, 2015, “Asset managers pour billions into direct lending,” The Financial Times (https://www.ft.com/content/23bc5496-a026-11e5-beba-5e33e2b79e46) and http://www.gtlaw.com/portalresource/lookup/wosid/contentpilot-core-401- 28023/pdfCopy.name=/GT%20Alert_What%20Every%20Fund%20Manager%20Wants%20to%20Know%20about%20the%20ECI%20Rules%201%201.pdf .}

^{[13] https://www.velaw.com/WorkArea/DownloadAsset.aspx?id=12884906201.}

^{[14] https://www.sec.gov/Archives/edgar/data/1619739/000119312517113755/d101223d424b4.htm.}

^{[15] Form S-1, March 31, 2014, https://www.sec.gov/Archives/edgar/data/1176948/000104746914003231/a2219379zs-1.htm.}

^{[16] Form S-1/A, May 1, 2007, https://www.sec.gov/Archives/edgar/data/1393818/000104746907003476/a2177304zs-1a.htm.}

^{[17] Form S-1, September 6, 2011, https://www.sec.gov/Archives/edgar/data/1527166/000095012311082561/w83442sv1.htm.}

^{[18] Form S-1, July 3, 2007, https://www.sec.gov/Archives/edgar/data/1404912/000104746907005446/a2178646zs-1.htm.}

^{[19] https://www.sec.gov/Archives/edgar/data/1380393/000095013606010504/file1.htm.}