As Kinder Morgan deal shows, taxes can’t be put off indefinitely

Don’t you hate it when that good thing that you hoped would last forever comes to an end?

Many retail investors in Kinder Morgan Energy Partners and El Paso Pipeline Partners are probably feeling that way now that they understand the tax implications of an acquisition by Houston-based Kinder Morgan Inc.

But the warning signs that these master limited partnerships were doomed have been growing for years as the cost of capital grew high and higher, and no tax bill can be put off forever.

That should be the lesson for those who bought MLP units, the term used to differentiate securities in a partnership from shares in a corporation.

Many investors bought units in the Kinder Morgan family of MLPS because they offered the magical qualities of large payouts and deferred taxes. And because they were units in a partnership, not stocks or bonds, they could be passed down for generations with the tax deferral intact until the units were sold.

CEO Rich Kinder created the two partnerships to raise capital for oil and gas pipelines and his company pioneered the modern MLP model. But MLPs that offer general partners unlimited units as compensation have their limits, and Kinder announced on Aug. 10 that the parent company was buying the two publicly traded partnerships that it has been managing. The partners, or unit holders, will be paid with shares of Kinder Morgan Inc. stock.

Wall Street rewarded all three equities with a major price boost, but soon critics were questioning whether the $20 billion income tax savings that Kinder Morgan says it will earn over 14 years is coming at the expense of unit holders who may be left with fat tax bills.

“It depends on where you bought the stock and when you owned it,” said Becca Followill, Head of Equity Research at U.S. Capital Advisors. “For a guy who bought it over the last couple of years ... this is a great deal. For someone who bought it many, many years ago ... it’s not as good, and in fact it may be bad

for them.”

First, it’s important to understand that an MLP is a publicly traded firm, which must derive 90 percent of its cash flow from real estate, natural resources or commodities. Limited partners supply the capital and then share in the profits based on the number of units they own, while general partners operate the company and are compensated based on the partnership’s performance, often by earning units of the partnership.

Some investors like MLPs because they provide a steady, reliable income, and the partnership is obligated to make distributions. Both of these partnerships have consistently posted yields greater than 5 percent at a time when 10-year Treasury bills have been paying below 3 percent.

Limited partnerships also pay no corporate income taxes. Instead, the partners pay taxes on the distributions. In most cases, unit holders can defer the taxes until they sell their units. But as times passes, the general partners can earn an ever larger share of the revenue. In this case, Kinder Morgan Inc. is the general partner operating El Paso Pipeline Partners and Kinder Morgan Energy Partners. After 17 years, Kinder Morgan Inc.’s share amounts to 45 percent of the firms’ income.

Steve Kean, president and chief operating officer of Kinder Morgan Inc., told me that the firm’s executives knew they needed to change the structure in order to lower the cost of capital and invest in more projects. Any plan had to meet two goals, benefit all the unit and shareholders in all the firms and bring about fundamental, longterm change that would make the company competitive at a time when the U.S. needs an estimated $640 billion worth of new energy infrastructure.

“We can’t say definitively that there is not a single unit holder — for example someone who wanted to hold the security all the way through to death and have it pass on to their estate without tax consequences — that will not be better off, but what we can say is the vast majority of unit holders are better off,” he said.

Savvy investors know that any MLP that is growing and compensating general partners with units in the firm will likely end up in the dilemma faced by Kinder Morgan, with the general partners collecting an inordinately high percentage of the income. The fact that Kinder Morgan was “up in the splits” was clear in the company’s news releases.

“The street anticipated that Kinder needed to do something because they were so high up in the splits it was impeding their ability to grow,” Followill told me.

The surprise was that Kinder Morgan Inc., a corporation that was acting as the general partner to the MLPs, was the purchaser of the partnerships.

Several law firms have announced that they are investigating the merger to determine if there are any grounds to stop it, but Wall Street has already expressed its approval and more than 36 percent of the unit holders are almost guaranteed to vote in favor of the transaction.

The retail investors who are caught off guard, and who may now be forced to pay unexpected taxes or to change their estate planning strategies, should take this as another lesson that nothing lasts forever, and death and taxes will always be certain.