Will the Proposed Tax Reforms Spell the End of MLPs?

President Trump has so far only released an outline of his plan, and the Republican plan currently in the House is also subject to change. Despite Trump’s optimism that tax reform will be completed this year, it could be into 2018 when changes take effect. Given that considerable uncertainty, we will assess in broad strokes the potential changes given what information is currently available.

Right now, the major proposed changes include:

First and most obviously: MLPs are pass-through entities that pay no federal income tax, so, surface answer is that changes to the federal tax code shouldn’t affect them. Unfortunately, it’s rarely that easy. Since the income isn’t tax-free, just passed-though, someone does pay the tax. But, with the individual rate also proposed to be cut, fewer taxes would already be collected.

Impact of Lowered Corporate Income Tax
On newly forming companies. While there would be little change made to a model of an MLP’s performance, the more likely concern is competitive advantage. Not only will new companies have less incentive to choose the structure, a lowered corporate tax rate would decrease the benefit differential to an MLP investment. We could expect fewer new MLP IPOs.

On existing MLPs converting to C corporations. This is another version of the Kinder question: will more MLPs convert to C corporations? Again, paying 0% in federal taxes is better than 15%, but since energy infrastructure companies are continually building assets and taking advantage of accelerated depreciating accounting rules, their tax burden would already be quite low. Without the strictures of the MLP structure, they could opportunistically expand into businesses that are not currently permitted under the IRS rules as well as benefit from a broader investor base (since most investors balk at receiving K-1s).

On the MLP investor base. Under the current system, the Alerian MLP Index (AMZ) yields around 7%, and the S&P500 yields around 2%. If the corporations in the S&P500 pay less in taxes, they have more money available to distribute to shareholders. REITs, which also are pass-through entities, yield around 4%. As interest rates continue to rise, making bonds more attractive (eventually), and as dividends increase from traditional corporations, the thirst for yield present in the market for the past several years will at last, start to be satisfied. Unfortunately for MLPs, that means there may be less yield-based demand for them. The income-focused portion of the MLP investor base might be distracted by other shiny, high and stable yields.

At first blush, this is not encouraging; however, yield is not the only reason to own MLPs, despite what some media outlets and your wacky cousin want you to believe. The real asset exposure and participation in US energy infrastructure remain unaffected by changes to the tax code. In fact, it’s possible that as yield-driven money turns its focus away from MLPs, smart money can again begin to influence valuations.

Considering the impact this would have on the investing landscape, this increased desirability of 100% MLP funds could offset the argument that there may be less yield-based demand for MLPs due to increased demand for other yield-instruments as noted above. MLPs have traditionally been held at the individual level, but that has shifted towards funds ever since their invention (thanks primarily to the funds’ lack of a K-1). The lowered corporate tax rate on these funds would only strengthen that momentum.

Impact of Lowered Personal Tax Rate
The proposed changes would bring the corporate tax rate down to 15%, and the highest individual income bracket down to 35%. While this could incentivize some highly-paid salaried workers to become independent contractors in order to pay less in taxes, it could also incentivize investors in partnerships and LLCs to hold their investments. Such an obvious loophole could lead to blatant exploitation, which generally leads to elimination of loopholes. As with any proposed tax change impacting pass-throughs (and although this is quite unlikely and we’re already down a rabbit hole) there would be a risk of MLPs being caught up in legislation and the structure eliminated.

Miscellaneous Impacts
New 20% Tax on Imports. MLPs prefer to lock in the IRR for any new project before a shovel breaks ground. This involves signing contracts with both customers and with suppliers; however, there remains some exposure to price fluctuations. If imported steel becomes more expensive, that can drive up costs. On the other hand, a tax on imported crude oil would benefit domestic producers who move their products on MLP pipeline systems.

No tax on foreign earnings at corporate level. This could make foreign investment more attractive as compared to an investment in MLPs. That said, there aren’t really similar fundamental energy infrastructure opportunities abroad, given that the US is one of the few countries to have privatized, investable energy infrastructure.

Elimination of the inheritance tax. Many investors use MLPs for estate planning purposes. Since 70%-90% of the distribution in a given year is often categorized as return of capital, it lowers the cost basis. This tax-deferral mechanism is powerful by itself, but when an MLP with a very low cost basis is passed along to heirs in an estate, the heirs receive a step-up in the cost basis and the tax on that recapture is not owed. Without inheritance tax, the estate-planning-based demand for MLPs could lessen.

Vague Questions Get Vague Answers
Without a concrete tax plan, the majority of these implications remain thought experiments. Charts, data, and firm calculations will have to wait. In the meantime, the giddy optimism that a lowered corporate tax rate would provide an immediate benefit is probably over-enthusiastic. At the same time, apathy resulting from a too-simplistic view that 0% < 15% is perhaps too relaxed. As always with MLPs, it’s complicated and we’ll keep watching it.

 

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