Monday Mailbag: When 89% Is Considered Failing

10/26/15 | Karyl Patredis

What happens if an MLP fails to meet Section 7704 income requirements?

Up until fifth grade, I’d always received marks well above 90% on my report card. It wasn’t until an unfortunate run-in with the Shurley Method (where I became more focused on learning the melodies and dance moves of the jingles than the words) that I found myself with an embarrassing, heartbreaking 89% on my progress report. I remember crying wildly when I showed it to my mom. Dipping below 90% seemed like the end of the world and a monumental failure. Similarly, while the sun will likely still rise, if an MLP fails to have 90% or more of its gross income recognized as qualifying income by the IRS, the MLP’s executives may also find themselves crying wildly.

The modern MLP structure was created by an act of Congress. Almost three decades ago, Congress passed the Tax Reform Act of 1986, signed by President Ronald Reagan on the South Lawn of the White House. In addition to eliminating a number of tax shelters, it defined the structure of the modern MLP. Congress limited the scope of MLPs via Section 7704(d) of the Internal Revenue Code, part of the Revenue Act of 1987. It stated that “a publicly traded partnership shall be treated as a corporation” for tax purposes unless 90% or more of its income is derived from qualifying sources in the current tax year and each subsequent taxable year after December 31, 1987. As it currently stands, Section 7704(d)(1), the relevant section for energy MLPs, defines qualifying income as follows:

(A) interest, (B) dividends, (C) real property rents, (D) gain from the sale or other disposition of real property (including property described in section 1221(a)(1)), (E) income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber), or industrial source carbon dioxide, or the transportation or storage of any fuel described in subsection (b), (c), (d), or (e) of section 6426, or any alcohol fuel defined in section 6426(b)(4)(A) or any biodiesel fuel as defined in section 40A(d)(1), (F) any gain from the sale or disposition of a capital asset (or property described in section 1231(b)) held for the production of income described in any of the foregoing subparagraphs, and (G) in the case of a partnership described in the second sentence of section 7704(c)(3), income and gains from commodities (not described in section 1221(a)(1)) or futures, forwards, and options with respect to commodities.

In other words, by limiting themselves to handling minerals and natural resources, MLPs do not pay federal income taxes at the entity level, and are able to pay out more of their cash flow to investors. Corporations, on the other hand, pay federal income taxes of up to 35%.

If an MLP fails to meet gross income requirements and the Secretary of the Treasury determines that the failure was unintentional, the partnership will be given a grace period, provided that it agrees to make adjustments dictated by the Secretary. According to Vinson & Elkins, a reasonable time period for this is one year. If the Secretary concludes otherwise, the MLP will be taxed as a corporation effective as of the first day of the year in which the failure occurs.

An MLP that wants to acquire an asset that is known to generate non-qualifying income may do so by creating a corporate subsidiary, paying taxes therein, and kicking the after-tax income up to the MLP in the form of a dividend. An example of this is Sunoco LP (SUN), which formed a corporate subsidiary called Susser Petroleum Property Company LLC to house SUN’s convenience store income.

Keeping gross income above the 90% qualifying income mark is critical to the survival of an MLP. Unlike me and my fifth grade report card, where my shame was my punishment, MLPs don’t get off quite so easy. The punishment for not meeting the threshold could cause serious financial damage and loss of investor base.