KMI Merger Brings a Big Tax Bill for MLP Investors

Here's why the merger will trigger tax liabilities but ultimately good results for KMP, EPB unitholders

   
KMI Merger Brings a Big Tax Bill for MLP Investors

Kinder Morgan Inc (KMI) issued a press release Aug. 10 stating that it will be merging itself, Kinder Morgan Management LLC (KMR), Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB) by the end of 2014 under one umbrella C corporation structure. From the mega-deal, all outstanding unitholders will receive KMI shares, but for KMP and EPB, the exchange will virtually be treated and taxed as a sale, which will trigger tax liabilities for those limited partners.

Typically, most initial distributions of a master limited partnership are treated as return of capital and are not taxable income for the year, but they decrease the cost basis of the unitholder. Once the cost basis reaches zero, the distributions are treated as long-term capital gains.

Basically, if you purchased shares in the Kinder Morgan Energy Partners MLP at the end of 2002 for about $35 and have received $46.30 in distributions since, then the first $35 you received in distributions would have been treated as return of capital and thus non-taxable in the year received. However, those distributions would be tax-deferred only. So, a sale would trigger tax liabilities, and those distributions would be taxed at ordinary income rates. The next $11.30 in distributions would have been taxed as long-term capital gains, which receive preferential tax treatment.

When the KMP and EPB shares become KMI shares, those MLP unitholders will have to pay ordinary income rates on all recaptured depreciation and long-term capital gains rates for anything in excess of the purchase price and value received at the time of conversion to corporation. Therefore, KMI will distribute cash to KMP and EPB unitholders to pay those taxes on their deferred gains. On the bright side of course, if a unitholder owned $95 worth of KMP shares and received $95 in KMI shares, his basis in the shares will be $95.

Of course, you didn’t buy KMP units just for the tax benefits, did you? You bought Kinder Morgan Energy Partners MLP because of its solid management, good purchase price and promising future returns. Furthermore, Kinder Morgan Chairman and CEO Richard D. Kinder declares:

“All shareholders and unitholders of the Kinder Morgan family of companies will benefit as a result of this combination…Everyone will hold a single, publicly traded security – KMI – which will have a projected dividend of $2.00 in 2015, a 16 percent increase over the anticipated 2014 dividend of $1.72. We expect to grow the dividend by approximately 10 percent each year from 2015 through 2020…”

I like that those solid incentives for shareholders are aligned with those of the main shareholder, Kinder himself, who I believe to be the Warren Buffett of the energy sector.

The merging of all four Kinder Morgan MLP entities will increase the total pipeline and other fixed assets that KMI will then own and depreciate as if they were brand new assets. Plus, the streamlined corporate structure will have a lower cost of capital because there won’t be those incentive distribution rights any more. As a result, Kinder estimates $20 billion in savings, which will feed back to the unitholders. The Kinder Morgan MLP entities will merge to likely become even stronger dividend-paying stocks, but in the meantime, MLP unitholders will not be happy come tax season.

Full Disclosure: Long KMR and KMI

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Article printed from InvestorPlace Media, http://investorplace.com/2014/08/kinder-morgan-mlp-kmp-epb/.

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