MLP investors face prospect of new taxes after Kinder Morgan deal

A $44 billion deal to buy out the investors in Kinder Morgan Inc.-affiliated energy partnerships comes with potentially serious tax ramifications for those investors, tax and financial advisers said Monday.
The deal, announced Sunday, is poised to become the second largest in the history of the energy business. It also marks a pivotal point for a firm long associated with pioneering the partnership business structure as a way to deliver tax-advantaged returns on energy investments.
Houston-based Kinder Morgan plans to acquire the commonly controlled oil-and-gas pipeline partnerships Kinder Morgan Energy Partners L.P. (KMP) and El Paso Pipeline Partners L.P. (EPB), as well as Kinder Morgan Management (KMR), a holding company.
In a conference call Monday morning Kinder Morgan chairman and chief executive Richard D. Kinder cited a range of benefits to the company’s shareholders, including streamlining the company’s investments, making it less costly to take on debt and easier to use company stock for future acquisitions. He also said the company would earn “after-tax treatment” of its debt as a result of the transaction.
“As the largest shareholder of KMI, I certainly would not be doing this transaction if I didn’t believe it promised enormous benefits for all of the KMI shareholders,” Mr. Kinder said.
Yet even as the company sets itself up for dramatically reduced taxes and costs, investors who own the firm’s affiliated MLPs face an unexpected bill.
(More: Energy boom blasting out master limited partnership opportunities)
“To a lot of people they were planning on holding these thing for a long time and not paying a tax until they sold it or died, so it’s probably going to be a bit of a surprise for those people,” said Robert N. Gordon, president of Twenty-First Securities Corp., a New York-based broker-dealer.
Kinder Morgan’s (KMI) stock price rose 10% to $39.82 in afternoon trading. Shares of the three affiliated firms were up between 18% and 25%.
Kinder Morgan spokesman Larry Pierce confirmed the deal would be a taxable transaction for owners of KMP and EPB. KMR owners will have the benefit of a tax-free transaction, according to a company presentation.
Advisers who use master limited partnerships often do so in search of higher yields, returns that don’t move in line with equity markets and because the partnerships’ investors — known as unit holders — enjoy unique tax advantages.
Kinder Morgan is an investor in or operator of about 80,000 miles of pipelines, among other investments.
The newly combined corporate entity is likely to enjoy substantial tax benefits at the expense of some current unit holders, according to Robert Willens, a New York-based tax adviser.
“It could’ve been fairly easily made into a tax-free transaction — all they would’ve had to do was create a new corporation to serve as the acquiring company,” Mr. Willens said.
But doing so would have deprived the company of a tax convention, called a step-up in basis, which allows it to use a higher valuation of the acquired firms when calculating its liabilities. Doing so will allow the new Kinder Morgan to “eliminate all or most of its taxable income” associated with those companies’ increased value, according to Mr. Willens.
For unit holders, some of the gains earned in the transaction will be taxed as income and the remainder will be capital gains, according to Mr. Willens. He said the mix is hard to estimate, but he expects more than half of the gains in the transaction will likely be taxed at the ordinary income rate, which maxes out at 39.6% for 2014, rather than as a capital gain, which tops out at 23.8%.
(More: Why corporate inversions could mean higher tax bills for your clients)
But one adviser said some investors will prefer the new format, which will eliminate a tax schedule known as a K-1.
“The tax reporting side of things will actually be easier for the owners because K-1s can be very onerous and certainly create more tax-reporting responsibility than merely throwing dividend income on your tax return,” said James H. Guarino, an accountant and financial planner at New Wealth Advisors.
The transaction will also mean changes for some mutual funds and exchange-traded funds. Those that invest in MLPs are not likely to continue buying Kinder Morgan as a result in its change in corporate structure, according to Todd Rosenbluth, director of ETF & mutual fund research for S&P Capital IQ, a research firm.
This article has been updated to indicate that capital gains taxes top out at 23.8%, not 20%.