For more than 60 years, the Tennessee Gas Pipeline has linked natural-gas wells in Texas to customers in the north. Until last year, it paid federal corporate income taxes on its earnings, setting aside $107 million in 2011 alone.
Then in August, Houston-based Kinder Morgan (KMP) Energy Partners LP bought the pipeline. Because of a little-known subsidy that annually costs taxpayers hundreds of millions of dollars, Tennessee Gas’s bill dropped to zero and stayed there.
Kinder Morgan is one of the biggest of about 90 tax-free publicly traded partnerships that have taken over the U.S. pipeline business and are expanding into the rest of the oil and gas industry, partly by gobbling up dozens of tax-paying companies. The break for these “master limited partnerships” will cost taxpayers about $1.5 billion from October 2010 through September 2015, Congress’s Joint Committee on Taxation estimated last January.
The product of an exception to a 1987 tax law, publicly traded oil and gas partnerships generated a record $16.7 billion in pretax profit in 2011, up from $7.2 billion in 2007. Their market value has swelled more than 12-fold in the past decade to about $340 billion. Founders such as Kinder Morgan’s Richard Kinder are now billionaires. Thirteen MLPs went public in 2012 in an otherwise lackluster year for stock debuts.
Congress broadened the break in 2008, adding $12 million a year to the cost borne by taxpayers. It may consider legislation this year to make more companies eligible, even as President Obama and congressional Republicans call for a corporate tax overhaul that includes eliminating some breaks. Canada ended a similar break in 2011, saving an estimated $500 million a year.
“The people who say they want deficit reduction, how do they justify expanding it” with subsidies, said Representative Keith Ellison, the Minnesota Democrat who sponsored an unsuccessful bill last year to end oil and gas tax breaks, including the one for MLPs. “These industries are some of the most profitable in the country.”
Kinder Morgan emphasizes that lawmakers set up the tax exemption. “Congress made a conscious decision to encourage investment in energy infrastructure through the MLP structure,” Larry Pierce, a spokesman for the company, said in a statement.
“The overall tax break is not huge,” said Park Shaper, president of Kinder Morgan Inc., which controls the Kinder Morgan partnerships.
The Internal Revenue Service, which referees which kinds of businesses can form MLPs, is encouraging their spread. Among a record number of rulings on the matter last year, the IRS said in October that companies that convert natural-gas liquids into ethylene, an ingredient in plastics and antifreeze, could form MLPs. Dow Chemical Co. (DOW) was among stocks that rallied on the news as investors speculated the companies might spin off plants into tax-free vehicles.
U.S. corporations face two levels of taxation — they pay corporate income tax at a top federal rate of 35 percent, and their shareholders pay again in personal income tax on dividends and capital gains.
MLPs legally avoid taxes by removing one of the layers. Though they have thousands of investors and are traded on exchanges, including the New York Stock Exchange, they are associations of individual partners. Each of those partners counts a share of the company’s profits as ordinary personal income.
The tax that partners pay on that income offsets to some extent the government’s loss of revenue from corporate taxes.
However, MLP investors often can defer those personal taxes through a complicated process by which they are allowed to recognize depreciation on the company’s assets.
As a result of this “tax shield,” as the benefit is known, about 20 percent of payouts to partners of a typical MLP are taxed immediately. The remainder is deferred, according to a Wells Fargo & Co. research note.
Because MLP’s regularly pay out all of their available cash to investors, they are especially popular in the current low- interest rate environment. Yields on 10-year Treasuries fell to less than 2 percent last year, compared with yields on the Alerian MLP Index (AMZ) of about 6 percent.
That has led a variety of companies connected to the energy industry to switch to the MLP structure. New MLPs that went public in the past two years include CVR Partners LP, which uses refinery byproducts to make fertilizer, and Hi-Crush Partners LP, which digs up the sand used in the hydraulic fracturing of oil and gas wells.
The proliferation of unconventional MLPs benefiting from the tax break may pose risks for investors who assume they can depend on stable cash payouts like those from pipelines, said Christopher Eades, who manages $4.2 billion in MLP securities at ClearBridge Advisors LLC in New York.
“People have gotten lulled into thinking that all MLPs are low-risk, high-yielding securities,” said Eades, who said he avoided most of last year’s “non-traditional” offerings. “While that’s generally true, you can’t make that statement for every MLP out there.”
In the months after Oxford Resources Partners LP, which operates coal mines in Appalachia, went public in July 2010, the price of its securities increased as much as 58 percent to $28.34. It has lost more than half of its value since last October, when it slashed its cash payout as a result of low coal demand, and now trades at about $5.
In 1981, an oil producer subsidiary of Apache Corp. became the first publicly traded partnership. At the time, all partnerships, whether closely held or public, did not pay corporate income tax.
By the mid-1980s, such companies as Burger King and the Boston Celtics were creating listed partnerships, leading to concerns that U.S. tax receipts would erode. Congress acted in 1987 to bring them back on the tax rolls — except for a few industries, notably oil and gas.
Lawmakers calculated that exempting energy companies, which accounted for most of the tax-free partnerships, would make the ban more likely to win support, said John Buckley, who as a Democratic congressional aide helped draft the law.
“You try to mitigate the political opposition by not touching the people who are currently using it,” he said. In addition, the Reagan administration maintained that building more pipelines would help the nation’s energy security.
The authors of the exception didn’t envision how popular the tax break would become. “It is an example of a decision that was made for one reason that has proved to be far more consequential than people thought,” said Buckley, now a tax professor at Georgetown University Law Center. “I don’t think anybody expected the dis-incorporations of pipeline assets that have occurred.”
As a result of the exception, more energy corporations that were subject to U.S. taxes shifted assets to publicly traded, tax-free partnerships. Lawmakers broadened the break in 2008, benefiting Kinder Morgan and other MLPs.
Amid lobbying from the trade association representing MLPs, lawmakers inserted a section into an energy bill that allows the partnerships to transport and store biofuels such as ethanol. By 2010, Kinder Morgan estimated it was handling 25 percent to 30 percent of the U.S. market for renewable fuels.
As the size of the MLPs has grown, so too has their clout in Washington. Taken together, the trade association and managers of the largest partnerships have tripled lobbying expenses since 2007, to about $7 million in 2011, according to disclosure forms compiled by Bloomberg. Williams Cos., the Tulsa, Oklahoma-based pipeline operator, alone spent $3.8 million.
The latest push in Congress seeks to expand the break further. Senator Chris Coons, a Delaware Democrat, proposes to extend the benefit to clean energy companies such as wind and solar producers, an industry that has relied on Democrats for support. Coons said the renewable energy industry should have the same advantages of fossil-fuel producers.
The measure will probably win support from pro-oil Republicans because it would help protect the original MLP tax break in a corporate overhaul, Coons said at an event in Washington last month, according to an account of his remarks in The Hill newspaper.
“This is a way that everybody can win,” The Hill quoted Coons as saying. Republicans who have signed on include Representative Ted Poe of Texas and Senator Lisa Murkowski of Alaska.
“We’re all for it,” said Shaper, the Kinder Morgan president. “It is an effective means to encourage investment.”
The Obama administration has gestured to both sides. In a framework for corporate tax reform issued last year, it proposed lowering the top corporate rate to 28 percent and covering the cost in part by eliminating breaks such as MLPs. In December, Energy Secretary Steven Chu endorsed the Coons proposal.
The MLP break is “a perfect example of how we end up in the mess we’re in,” said Edward Kleinbard, a law professor at the University of Southern California in Los Angeles and a former chief of staff for the Joint Committee on Taxation. “Those who don’t have the subsidy ask for it, rather than asking for its repeal. Subsidies like this expand and expand.”
Dozens of corporate tax expenditures cost the government as much as $151 billion in 2012, according to the Tax Policy Center.
The MLP tax break helped create the third-largest energy company in North America in just 20 years. The market value including net debt of the Kinder Morgan partnerships, combined with parent Kinder Morgan Inc., is smaller than only Exxon Mobil Corp. and Chevron Corp.
Richard Kinder left Enron Corp. in 1996 after he was passed over for the chief executive officer’s job. He lost out to a college classmate, Kenneth Lay.
Shortly after he departed, Kinder and Bill Morgan bought the general partner of a publicly traded pipeline partnership for $40 million from Enron, which was shifting focus from operating pipelines to trading gas and power.
Kinder later described the acquisition as a collection of “sleepy, old pipelines.” At the time, there were about 19 publicly traded energy MLPs together worth about $9 billion, according to data compiled by Bloomberg. Most were stable, slow- growing businesses akin to toll roads, charging fees to energy companies for hauling hydrocarbons across the country.
Kinder embarked on a 15-year buying spree, using his tax advantage to outbid competitors for pipeline assets. That allowed him to regularly increase the amount of cash his partnership paid out to members, earning him a premium market value and returning an annualized 19 percent over the subsequent decade. Kinder Morgan and its related companies have 75,000 miles of pipelines, enough to circle the globe three times.
Since Kinder took over in 1997, the main partnership he oversees, Kinder Morgan Energy Partners LP, has made more than $12 billion before taxes. The partnership set aside about 3 percent for taxes, such as payments in other countries and payments to state governments. The federal corporate income tax rate is 35 percent.
Tennessee Gas Pipeline Co., acquired by Kinder Morgan Energy in August, said in regulatory filings that it set aside a total of 36 percent for federal and state taxes in the three full years before its sale. Pierce, the spokesman for Kinder Morgan, said the company is now part of the partnership, which doesn’t pay U.S. corporate income taxes.
He added that Kinder Morgan Inc., the general partner that controls the company’s partnerships, pays federal corporate income taxes amounting to $3.4 billion since 1997.
That growth has rewarded Kinder and the other founders of MLPs, creating some of the newest fortunes in Texas. He’s now the richest man in Houston, with a fortune Bloomberg estimates at $10 billion. The previous holder of the title, Dan Duncan, ran the second-biggest MLP, Enterprise Products Partners LP (EPD), before he died in 2010. Forbes estimated his net worth at about $9 billion.