The cool thing about master limited partnerships (MLPs) is that they offer both sponsoring firms and investors a way to defer and skirt the taxable liability of assets placed within the structure. As pass-through entities, MLPs often kick out high distributions. That cash is often considered return of capital, which lowers your cost basis and isn’t taxable when first received. It’s a great loophole for investors looking to score yields in the 5%-7% range.
Perhaps, it is too good of a tax loophole.
As more firms have tried to use the structure, the Internal Revenue Service has become wary of all the money it stands to lose from MLPs. So, the IRS decided to renege on some previously OK’d MLPs, which sent shares of two particular MLPs into the toilet.
But, for these two firms, there may still be sunshine on the horizon. For investors, they could represent two insanely beaten-down values in the MLP space.
“Chemical Change” A Big No-No For MLPs
Changes to the tax code back in 1986 allowed for pipeline firms to be structured as partnerships to stimulate construction of domestic energy infrastructure. This allowed MLPs to avoid paying corporate taxes by passing on most of their free cash flow as tax-deferred distributions to investors. That section of the tax code specified that only businesses whose “income and gains [are] derived from the exploration, development, mining or production, processing, refining, transportation or the marketing of any mineral or natural resources” can qualify.
But, that definition is pretty broad, and in recent years, many firms have petitioned the IRS to receive private letter rulings. Such rulings allow firms to finagle their way into MLPs and are responsible for a surge in the number of MLPs in recent years.
Unfortunately, the IRS seems to have realized it had granted approval to too many MLPs. To that end, the IRS backtracked and defined new rules for what constitutes qualifying income for an MLP.
While the actual rules are typical IRS legal mumbo jumbo, the big key involves “chemical changes.” That means companies such as International Paper (IP) must shelve plans to spin off certain paper mills into MLPs. It also means that many chemical manufacturers can’t use the lucrative tax structure to drop ethane crackers or similar facilities into an MLP.
That’s a huge problem for Westlake Chemical Partners LP (WLKP) and SunCoke Energy Partners LP (SXCP). Both companies had already received private letter rulings and were the first chemicals MLPs to hit the markets about a year ago.
WKLP, which is sponsored by Westlake Chemical (WLK), owns a stake in an operating company that controls ethane crackers. SXCP, which is sponsored by SunCoke Energy (SXC), owns both terminaling assets and facilities that convert raw metallurgical coal into coke. However, under the IRS’s new rules, WKLP and SXCP no longer qualify as MLPs.
Needless to say, both WLKP and SXCP have cratered on the news. WKLP is down about 38% from its highs, while SXCP is down nearly 50%. Yet, even with the IRS’s ruling, investors willing to take a gamble may want to consider the pair.
Still a Chance for these Two MLPs
Both WLKP and SXCP have a ten-year phase-out period before they lose their MLP status. In market time, ten years is an eternity. Investors will still be able to snag high, increasing tax-deferred dividends over the course of that period.
Realistically, that’s a long enough timeline that the return of capital via distributions could lead to a cost basis of $0, so investors would only need to pay taxes on the dividends. The MLPs yield 5.2% and 14.3%, respectively.
Since the pair already has private letter rulings and are already trading, there’s a good chance they may be grandfathered into MLP status. Both West Lake and SunCoke have filed petitions with the IRS to permanently retain their MLP status, or in the least extend the deadline.
Much of the downside from the IRS rulings is already baked into share prices. If the IRS grants managements’ requests, there could be an immediate snap-back in WLKP and SXCP shares.
If that doesn’t happen, many pundits have already speculated that WLK and SXC could buy out their MLPs when the tax advantages have ended, if not beforehand. Worst case scenario as an investor, you’ll end up owning equity in an ordinary corporation. The dividend probably won’t be as high, but remember you’ve had ten years of tax deferral. Odds are you’d have to pay taxes on those payouts anyway.
As for the firms themselves, WLKP is a safer bet. Ethane is a natural gas liquid used in plastics manufacturing. Since the fracking boom, ethane prices have cratered, leaving fat margins at WLKP’s three ethylene facilities. The beauty is that WLKP has agreed to sell the vast majority of its ethylene production back to WLK at a set margin. So, it’s guaranteed to profit.
SXCP is the riskier of the two, but investors are compensated for that risk with much higher yield. Remember, SXCP doesn’t mine coal, but instead transforms it into a finished product. As a matter of fact, SXCP is the largest producer of coke in the U.S. What’s more is that the bulk of its production is sold under long-term contracts to U.S. Steel (X) and AK Steel (AKS).
So, there’s risk, but not as much as at first blush.
Bottom Line on WLKP and SXCP
The IRS threw WLKP and SXCP a curve ball with regard to their MLPs. However, that’s left the pair attractively priced for the long term.
As of this writing, Aaron Levitt held no positions in any of the aforementioned securities. But, he is considering adding a position in WLKP in the near future.
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