Kinder Morgan Limited Partners Could Face Steep Tax Bills

As I touched upon earlier last week, Kinder Morgan is trying to combine all companies under a C-Corp corporate umbrella of Kinder Morgan Inc (KMI). The shareholders of Kinder Morgan Management LLC (KMR) will receive shares of Kinder Morgan Inc, which would not be a taxable event for them. Unitholders in Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB) will receive cash and Kinder Morgan Inc shares in exchange for their units.  This will create a taxable event for limited partners.

Typically, when you purchase units in a master limited partnership, most of initial distributions are treated as a return of capital. Those do not result in a taxable income for the year, but they decrease the cost basis of the unitholder. Once the cost basis reaches zero, the distributions are taxed at long-term capital gains rates. If the unitholder passes away, their children receive a step up basis in the units.

Is your head spinning yet? Basically, if you purchased Kinder Morgan Energy Partners (KMP) at the end of 2002 for about $35, you would have received $46.30 in distributions since then. The first $35 in distributions would have been treated as a return of capital and therefore been non-taxable in the year received. However, they would be tax-deferred only, since a sale would have triggered a taxable event and those would have been payable at ordinary income taxes. The next $11.30 in distributions received would have been treated as long-term capital gains, which receive preferential tax treatment.

If our limited partner decided to sell at $95 today, they would essentially have a long-term capital gain of $60/unit and an ordinary gain of $35/unit. The long-term capital gain will be taxed at 15% for most unitholders, and will result in tax of $9. The ordinary income gain of $35 would be taxable at ordinary income tax rates. Let’s say you were married, and both you and your spouse were in the 25% tax bracket. This would mean that you owe $8.75 in tax on that depreciation recapture. So in total, our limited partner would owe tax of $17.75.

Unfortunately, for those limited partners of Kinder Morgan Energy Partners and El Paso Energy Partners, the acquisition by Kinder Morgan Inc could result in triggering of tax liabilities.

When you sell your units for cash or have them exchanged into shares of Kinder Morgan, this creates a taxable event. In essence, the act of exchanging your Kinder Morgan Energy Partners units for Kinder Morgan Inc stock is treated as if you sold your units for cash. Therefore, a tax is due on all recaptured depreciation at ordinary income tax rates, and at long-term capital gains rates for anything in excess of the purchase price and value received at the time of conversion to corporation. On the bright side of course, if you received $95 in Kinder Morgan shares for your Kinder Morgan Energy Units worth $95, your basis in the shares will be $95. However, now I see why Kinder Morgan decided to offer cash to unitholders. Most will need that cash to pay their taxes on deferred gains.

Of course, you didn’t buy Kinder Morgan Partnership Units just for the tax benefits, did you? You bought Kinder Morgan because you believe in management, you believe you are getting in at a good price, and you believe that in the future the business will be able to generate more cash and pay more back to you. If you choose to hold onto your Kinder Morgan shares however, projections are for dividends to increase by 10%/year through 2020, which is not a bad rate of growth, considering the already high yield on the stock. I like that the incentives of shareholders are aligned with those of the main shareholder Richard Kinder, who i believe to be The Warren Buffett of Energy.

The acquisition of limited partnerships will increase the basis in pipeline and other fixed assets that Kinder Morgan Inc will now own. Kinder Morgan will get to depreciate those assets as if they were brand new assets. As a result, there will be $20 billion in tax savings from the proposed deal. In addition, the structure will be more streamlined, will have lower cost of capital because there won’t be those incentive distribution rights any more.

The lower cost of capital would mean that projects will generate more money right away, and the company would not have to dilute existing holders, because it sells too many units to grow. Retaining some cash flow for funding growth seems like a smart strategy. The company still needs growth projects in order to generate growth to pay for higher distributions down the road of course. Now with a single entity like Kinder Morgan Inc, it could use its stock as currency for further acquisitions. Given the track record of Richard Kinder, I am confident that he would be able to integrate any acquired companies into the Kinder Morgan umbrella quite successfully, while realizing synergies, higher profits for shareholders.

Full Disclosure: Long KMR and KMI

Relevant Articles:

- Kinder Morgan to Merge Partnerships into One Company
- Richard Kinder: The Warren Buffett of Energy
- Kinder Morgan Partners (KMP) for High Yield and Solid Distributions Growth
- Kinder Morgan Partners – One Company three ways to invest in it
- General vs Limited Partners in MLP's
- Master Limited Partnerships (MLPs) – an island of opportunity for dividend investors