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Revisiting MLP vs. C-Corp Taxation as Election Day Looms

07/09/20 | Michael Laitkep

Summary

  • Comparing the taxation of an MLP investment against the taxation of a C-Corp investment, MLPs possess a tax advantage of 7.2% over C-Corps. MLPs clearly benefit from not having to pay income tax at the partnership level, while MLP investors also benefit from the qualified business income deduction.
  • Assuming tax increases and other changes outlined under the Biden plan, the MLP tax advantage would increase from 7.2% to 16.9% as a result of higher corporate and qualified dividend rates, which would offset a repeal of the QBI deduction and an increase in the individual tax rate for the highest income tax bracket.
  • While taxation is only one factor in an analysis of potential C-Corp conversions, management teams will continue to weigh the MLP tax advantage against other considerations.

Despite an ongoing debate about the structure of MLPs versus C-Corps (read more), MLPs remain the most tax-efficient way to own midstream energy infrastructure assets. Even after the passage of tax reform in late 2017 that lowered the corporate tax rate, MLPs maintain a noticeable tax advantage over corporations. With a presidential election around the corner, today’s note revisits how the effective tax rate for an MLP investment stacks up against a C-Corp dividend and discusses how the benefits could be impacted by the Biden tax plan.

MLPs maintain a substantial tax advantage over C-Corps today.
Investors are often drawn to MLPs for their tax-advantaged yield, but the tax benefits of MLPs are often complex and potentially confusing. Today’s piece specifically analyzes the magnitude of the tax advantage MLPs possess over C-Corps for the individual investor. For a broad overview of tax considerations when investing in individual MLPs and MLP products, please refer to this recent note. While not discussed in this piece, it is important to keep in mind that the primary tax advantage of investing in MLPs is in the treatment of distributions, which are largely a tax-deferred return of capital. Setting aside cash distributions, MLP unitholders pay taxes on the net income allocated to them at their personal tax rate. Please remember that Alerian is not an accounting firm or tax consultant, and this piece does not constitute tax advice. For details specific to your situation and investments, consult a tax advisor. In addition, the views expressed in this piece are intended to be nonpartisan and are focused on addressing tax issues objectively.

The passage of tax reform through the Tax Cuts and Jobs Act (TCJA) brought a number of changes for individual investors and businesses alike beginning in 2018 (read more). For C-Corps, TCJA reduced the corporate tax rate from a graduated rate up to 35% to a flat 21% tax. As a way to balance the benefit, individuals invested in pass-through businesses such as MLPs were permitted to deduct up to 20% of qualified business income (QBI) under the act. In addition to lower individual tax rates, the QBI deduction has resulted in lower effective tax rates for MLP investors compared to prior years. The table below summarizes current tax rates for investments in MLPs and C-Corps. Note that the personal tax rate assumes an individual in the highest bracket, and all data excludes the Medicare tax of 3.8%. As shown, MLPs are currently taxed at an effective rate of 29.6% and possess a tax advantage of 7.2% over C-Corps. Including Medicare, the current MLP tax advantage for investors drops slightly to 6.6% over C-Corps. MLPs clearly benefit from not having to pay income tax at the partnership level, while MLP investors also benefit from the QBI deduction. The significant reduction of the corporate tax rate following tax reform has shrunk the MLP edge over C-Corps from 8.4% previously, but the difference is still significant.

While the decrease in the corporate tax rate is permanent barring new legislation, the reduction in the top individual tax rate and the QBI deduction expire after 2025 unless an act of Congress extends the provisions. Economic advisers in the Trump administration have previously floated the idea of “Tax Cuts 2.0.” The rumored plan includes reducing the individual tax rate to 15% for middle-income taxpayers, lowering the number of individual tax brackets, and making permanent some or all of the tax cuts from TCJA. Demonstrated progress on firming a proposal has been limited, with the most recent update from February suggesting the campaign would release a plan around September. However, clearly much has changed since February given significant spending to stimulate the economy in the wake of COVID-19. If there were to be a second term for the Trump administration, tax policy would likely remain largely the same.

What would a Biden presidency mean for MLP taxation?
While MLPs currently possess a significant tax advantage over C-Corps for individual investors, tax policies can obviously change under different presidential administrations and Congresses depending on the balance of power. Given that it is an election year, it seems appropriate to also evaluate the potential tax agenda of presumptive Democratic presidential nominee Joe Biden. First reported by media outlets in December, the Biden tax plan is expected to include an increase in the corporate tax rate from 21% to 28%, which would still be lower than the 35% rate prior to the TCJA. Corporate taxation is also expected to include a 15% minimum tax to ensure larger companies pay some portion of taxes. For individuals making more than $400,000, the 20% QBI deduction would be repealed for pass-through investments, and the highest income tax rate would revert to 39.6% from 37%. The plan would also reportedly tax long-term capital gains and qualified dividends at ordinary income rates for those making more than $1 million in income. The tables below include these assumptions and show their impact on the effective rates for MLPs and C-Corps, excluding the Medicare tax.

Notably, for top earners, the tax advantage of investing in MLPs would increase from 7.2% to 16.9%, enhancing the attractiveness of the MLP structure relative to the C-Corp structure. The larger MLP advantage stems from the higher corporate and qualified dividend rates, which would offset a repeal of the QBI deduction and an increase in the tax rate for the highest income tax bracket. While this example is kept simple for illustrative purposes, it is one reason why MLPs may not be rushing to convert to C-Corps before the election (read more). Structure questions have also likely taken a backseat to other concerns given macro headwinds this year, although management teams have fielded a few questions about potential conversions recently. On its 1Q20 earnings call on April 29, Enterprise Products Partners (EPD) co-CEO and CFO Randy Fowler said he expected taxes to increase for everyone in the future as a result of significant government stimulus spending, and the partnership is mostly watching to see what happens. Magellan Midstream Partners (MMP) also discussed taxes among its criteria for evaluating a conversion to a C-Corp structure on its 4Q19 earnings call on January 30. CEO Mike Mears said the company takes a long-term present value of MMP’s tax-efficient MLP structure and analyzes it against the present value of a C-Corp structure. Because C-Corps have to eventually pay taxes following a conversion, MMP believes there is more value in remaining an MLP but also evaluates its structure on an ongoing basis.

Bottom Line
MLPs continue to retain a tax advantage over their C-Corp counterparts, which could potentially widen under a Biden presidency if tax rates are raised. While taxation is not the only factor in an analysis of potential C-Corp conversions, MLPs will continue to weigh their tax advantage against other considerations.