How Trump’s Tax Reform Could Both Help and Hurt MLPs and Their Investors

President Trump released a framework for his tax reform in late September. This nine-page document is what members of Congress will use to write the final legislation, and so it understandably lacks the intricate detail necessary for a full analysis. While the administration still hopes to complete tax reform before the end of the year, it may need to wait until 2018. However, since I’ve been on the road the past couple weeks, I’ve been hearing that many investors and financial advisors are doing their tax planning early this year. In a world where so many asset classes are at all-time highs, advisors with MLP allocations are considering tax loss selling, and investors without an MLP allocation are considering establishing a position.

MLP investors are especially wary of potential taxation changes as most have gone to considerable trouble to get comfortable with all the associated nuances such as distribution recapturing, recording basis, and filing Schedule K-1s. Under the current system, MLPs are partnerships and tax pass-throughs. As such, investors typically pay tax on their portion of the MLP’s income at their own personal income tax rate. However, due to accounting rules and accelerated depreciation flow through, much of this (often 70%-90%) is considered return of capital and tax payments are deferred until sale. For investments in MLPs, handling these complexities is the price of admission.

The Relevant Proposed Changes, Taken Individually
Simplified Individual Tax Rates
According to Trump’s framework, the individual tax rate structure would be simplified to three brackets (from seven), and the highest rate would drop from 39.6% to 35%. With this lower rate, investors in the highest tax bracket would now pay slightly lower taxes on the portion of their MLP income taxable in the current year.

Corporate Tax Rate at 20%
The US corporate tax rate would change for the first time in 25 years, from 35% to 20%. Most management teams of existing MLPs agree that even a reduced tax rate would not incentivize them to convert from an MLP to a C corporation.

MLP investment products, which are themselves structured as C corporations, could also see a benefit as they would only need to accrue 20% instead of 35% in deferred potential federal income taxes.

While the performance of any given set of assets is unaffected by the way the company is taxed, the management team of a midstream company considering an IPO may choose one structure over another based on potential competitive advantage. A company that forms as an MLP gains beneficial tax status but is also limited in scope. The newly lowered corporate tax rate would also lower the relative tax savings of the MLP structure, potentially leading to fewer new MLP IPOs.

Immediate Expensing of Depreciable Assets
Most MLPs currently take advantage of accelerated depreciation rules, which is part of what enables them to classify a large portion of the distribution as return of capital. Immediate expensing could help drive that number even higher. The larger effect, however, would be to shrink the benefit of being an MLP even further. New or existing energy infrastructure companies could become C corporations and build (and expense) assets at such a pace that they could pay very low taxes.

Tax Rules Affecting Specific Industries
The framework remains vague here, suggesting “moderniz[ing] these rules to ensure that the tax code better reflects economic reality and that such rules provide little opportunity for tax avoidance” for industries that are currently receiving special tax treatment. Given the current administration’s emphasis on infrastructure projects, it would stand to reason that the beneficial tax structure afforded to MLPs would remain, as it has in nearly every other proposed tax reform legislation. However, if the objective of this tax reform is to equalize the playing field for all industries and sectors, anything is fair game.

Cumulative Effect of Tax Framework
Even if their industry specific tax benefit is maintained, there is a potential under this framework for some MLPs to convert. The simplified 1099 tax reporting appeals to a broad investor base, and since C corporations are eligible for inclusion in the S&P500, there is a possibility of accessing some of the billions tracking that index.

Given that the individual tax rate would now be higher than the corporate tax rate (helped by the five-year immediate expensing of assets), it’s possible that for a particular energy infrastructure company, an investor might have a higher after-tax return over the life of the investment if that company was structured as a C corporation instead of as an MLP. Please do not interpret this as a call for MLPs to convert to C corporations—the situation is not as simple as that! The return of capital benefit to MLP distributions as well as an individual investor’s holding period can dramatically change this analysis. Besides, the cost of conversion and the tax bills such a step would trigger could easily overwhelm any minor tax savings.

As this framework is only intended to serve as a guide for members of Congress who will write the actual legislation, final analysis must wait until the full documents become available.