How the I.R.S. Encourages Oil and Gas Spinoffs

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How the I.R.S. Encourages Oil and Gas Spinoffs

Master limited partnerships like Kinder Morgan have special tax codes that have unitholders paying tax on income at individual rates rather than the businesses paying it on a corporate rate.

Kinder Morgan, via European Pressphoto AgencyMaster limited partnerships like Kinder Morgan Energy Partners have special tax codes that have unitholders paying tax on income at individual rates rather than the businesses paying it on a corporate rate.

The grand bargain of the landmark tax legislation of 1986 was a deal for higher corporate taxes and higher capital gains taxes in exchange for lower rates on ordinary income. For the bargain to work, the boundaries of the corporate tax base had to be reinforced.

Among other things, Congress was concerned about the proliferation of master limited partnerships, also known as M.L.P.’s. These entities were publicly traded, like corporations, but were organized as partnerships under state law and avoided paying corporate taxes.

To protect the integrity of the corporate tax base, Congress passed section 7704, which provides the general rule that publicly traded entities should be taxed as corporations regardless of how they are organized under state law.

There is an exception to this general rule, however, for energy M.L.P.’s, defined as companies that derive at least 90 percent of their income “from the exploration, development, mining or production, processing, refining, transportation … or the marketing of any mineral or natural resource.” In other words, for the energy sector, paying the corporate tax is optional.

These days, more and more energy companies organize as partnerships and are therefore taxed on a pass-through basis, with M.L.P. unitholders paying tax on income at individual rates rather than the businesses paying it on a corporate rate.

The origin of this M.L.P. loophole is shadowy. The legislative history states only that in the case of the energy sector, “special considerations apply.” As I teach my students, that is code for “effective lobbying.”

The best rationale for the exemption, as far as I can tell, is that M.L.P.’s were traditionally passive vehicles for delivering a steady stream of income to yield-hungry investors. To the extent that an entity merely passes along royalties from a productive well or steady income from a pipeline, imposing an extra layer of corporate tax makes little sense.

The problem today is that M.L.P.’s are no longer the sleepy equivalents of regulated utility companies. Led by companies like Kinder Morgan Energy Partners, many M.L.P.’s are growth companies with volatile earnings. They hold out the promise of capital appreciation, not just steady income, to attract investors.

As more M.L.P.’s come to resemble normal operating companies, the tax loophole looks more like a straightforward tax subsidy for fossil fuel production. From an environmental standpoint, this is exactly backward. We should be taxing carbon production, not subsidizing it.

As with real estate investment trusts, the I.R.S. has made matters worse by carving the original loophole, brick by brick, into an opening big enough to drive an oil tanker through.

In a series of private rulings over the last few years, the I.R.S. has been exceedingly accommodating toward what counts as an energy M.L.P. The end result is that more oil and natural gas companies, and companies loosely affiliated with the industry, can legally skirt the general requirement that publicly traded entities must pay the corporate tax.

The definition of qualifying income goes beyond what you might expect from reading the statute. The I.R.S. has concluded, for example, that income from the supply and transportation of fracturing fluid – and the removal, treatment and disposal of fracturing flowback – constitutes qualifying income. So does income from the storage of fracturing fluid. Note that this is not the storage of oil or gas, but rather the storage of one element that goes into the production of oil and gas.

In another recent example, a company that provides hydraulic fracturing services to oil exploration and production companies sought to qualify as an M.L.P. The company does not explore, develop or extract oil and gas. It merely provides the equipment, on a contract basis, to the oil and gas companies. It is a bit like saying that a janitorial services company is in the real estate business because it cleans the building. The I.R.S. blessed the deal.

In other rulings, the agency has concluded that the management fees from operating assets owned by others can count as qualifying income. The principle seems to be that qualifying activities generate qualifying income, regardless of whether one owns the assets that generate the income (like owning the well) or merely provides services to the company that owns the assets.

The problem with this line of thought is that all sorts of services, like software, accounting, housing and legal services are also integral to the oil and gas industry. But that does not mean that a law firm’s income from providing legal services to oil and gas companies should be treated as “qualifying income.”

The I.R.S. rulings have made it easier for large companies like Marathon Petroleum, Phillips 66, Devon Energy and Valero Energy to consider spinning off midstream assets into separate companies that will operate as M.L.P.’s. Midstream assets refer to the transportation and storage systems that move crude or refined products from the upstream production and refinery sites to the downstream retailers.

Although a pipeline company fits squarely into what Congress seemed to have in mind for M.L.P.’s, the I.R.S. ruling encourages more assets and services that are incidental to energy production to be stripped out and spun off into M.L.P.’s, making the income produced exempt from the corporate tax.

As companies continue to structure deals in response to the rules, the corporate tax base continues to erode, deal by deal. If Congress is serious about a tax overhaul that would allow lower rates, it will have to rebuild the corporate tax base, as it did back in 1986.

For further reading, see Vinson & Elkins, I.R.S. Affirms and Expands the Scope of Qualifying Income for M.L.P.’s.

Victor Fleischer is a professor of law at the University of San Diego, where he teaches classes on corporate tax, tax policy, and venture capital and serves as the director of research for the Graduate Tax Program. His research focuses on how tax affects the structuring of venture capital, private equity, and corporate transactions. Twitter: @vicfleischer