Investors have struggled for years to squeeze income from their investment portfolios, with low rates on bank CDs and bonds forcing even conservative investors to consider more aggressive ways of putting their money to work. As a result, money has flowed into high-yield investments in the stock market, and many companies have taken steps to emphasize their income-generating potential by taking advantage of favorable tax laws to restructure their operations. In particular, in the red-hot energy industry, master limited partnerships have created an investing frenzy, with investors jumping at the chance to earn high yields with favorable tax characteristics and with dozens of major companies forming new MLPs to meet investor demand.
Yet a big move from one of the largest companies in the midstream energy industry flew in the face of that trend toward greater use of MLPs. That move has called the entire future of MLPs into question and has many investors asking whether they'll have to look elsewhere for high-yield opportunities.
The Kinder Morgan MLP bombshell
Earlier this week, Kinder Morgan Inc (NYSE:KMI) made a huge announcement, saying that it planned to restructure its network of master limited partnerships and consolidate its operations into a single publicly traded entity. Before the move, Kinder Morgan Inc stood at the top of a web of different businesses, acting as general partner of MLPs Kinder Morgan Energy Partners (NYSE:KMP) and El Paso Pipeline Partners (NYSE:EPB). In addition, Kinder Morgan Management (NYSE:KMR) was a separately traded corporate entity that holds units of Kinder Morgan Energy Partners, with Kinder Morgan as its parent as well.
With the deal, Kinder Morgan will spend $44 billion to buy out investors in its three subsidiaries. Unitholders of the two MLPs and shareholders of Kinder Morgan Management will have a choice to receive a combination of Kinder Morgan stock and cash in exchange for their interests in those entities.
The move has a number of benefits for Kinder Morgan and its investors. With a single dividend policy, investors will no longer have to decide which entity is best suited to their income needs. Simplification also played a key role, with complicated arrangements like the incentive distribution rights that Kinder Morgan received from its subsidiaries effectively disappearing.
But perhaps most surprisingly, Kinder Morgan argued that the move will save it huge amounts in taxes. Over the next 14 years, the company thinks it will pay $20 billion less in tax than it would have under the previous structure. The reason: By marking up the value of the pipelines and other assets that the entities own, Kinder Morgan will reset the clock on depreciation, allowing it to take larger tax deductions than it currently enjoys.
For investors, though, the news on the tax front isn't nearly as good. Because the MLPs will be deemed to have sold their assets to Kinder Morgan, MLP unitholders will owe capital-gains taxes on the excess of their value over their current depreciated tax basis. According to company estimates, taxes could cost some investors in Kinder Morgan Energy Partners roughly $12-$18 per unit, or as much as 20% of their current value.
Will MLPs still be around?
Because Kinder Morgan was instrumental in leading the revolution toward master limited partnerships, the company's about-face is notable. Some analysts speculated that other large energy entities might try to do similar consolidations of MLP assets into a single corporate structure.
Yet this isn't the first threat that master limited partnerships have faced. In the past, concerns among lawmakers about the use of MLPs to avoid corporate-level tax had led some to fear that Congress would eliminate the favorable tax provisions governing their use. More importantly, the IRS has temporarily stopped issuing private letter rulings approving the use of the MLP structure for new entities, citing the need for clearer and tighter standards on their use. A stronger move from the Canadian government almost a decade ago led to the end of the similar Canadian royalty trust system, forcing entities set up as high-yield royalty trusts to reincorporate and start paying taxes. That in turn led to reductions in dividends and hurt yields to shareholders.
At least for now, though, the rest of the industry is still embracing the master limited partnership concept. Once companies grow as large as Kinder Morgan, it becomes harder for them to find new opportunities that remain consistent with the MLP structure without raising costs of capital. For smaller companies, though, the popularity of MLP investments makes the structure their best way to attract investors.
Given their high yields, master limited partnerships aren't likely to disappear anytime soon. The biggest threat remains that the IRS and lawmakers will kill the tax benefits that MLPs enjoy, but that process will take time and is far from a certain outcome right now.
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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.