The IRS issued a proposed rule on the scope of qualifying income for MLPs
In April of 2014, the IRS put a temporary pause on private letter rulings (PLRs) regarding what business qualified for tax-free inclusion in energy master limited partnerships (MLPs). The IRS treats an entity as a partnership so long as 90% or more of the MLP’s gross income for every taxable year is derived from a qualified source.
The IRS lifted the pause in March, 2015, saying that it would propose a new rule regarding qualified activities for forming MLPs in the near future to help offer further clarity.
Definitions Difficult to Pin Down
On May 5, the IRS released its proposed rule for qualifying activity, but how useful it will be is a topic of debate among experts.
Under the proposed rule, qualifying activities for forming a MLP include: exploration, development, mining or production, processing, refining, transportation and marketing of minerals and natural resources – and certain limited support activities that are “intrinsic” to the activities of the MLP, according to the proposed IRS rule, which can be read here.
An activity can be considered “intrinsic” if:
- The activity is “specialized” to support a MLP activity;
- The activity is “essential” to the completion of the MLP’s activity; and
- The activity requires the provision of “significant services” to support the MLP’s activity.
“Specialized” refers to both personnel and property used for MLP activities. “. Personnel are specialized if they have received training unique to the mineral or natural resource industries that is of limited utility other than to perform or support a [qualifying activity],” while property must be used only in connection with a qualified activity, and cannot be easily converted for use for a different activity.
“Essential” refers to anything necessary to physically complete the qualified activity or comply with federal, state, or local law regulating said activity, such as water delivery and disposal for hydraulic fracturing operations.
“Significant services” would be any provided by personnel who have an ongoing/frequent presence at the site where the qualified income is generated and the personnel’s activates are necessary to support the qualified activity.
The grandfather period
The new regulations have left many MLPs that received positive PLRs wondering what will happen if their activities no longer satisfy the terms of being treated as a partnership. Some activities that were considered “qualified” may no longer be covered.
Westlake Chemical Partners (ticker: WLKP) issued a press release saying, “If the proposed regulations become final in their current form, such final regulations would make it difficult or impossible for the partnership’s production, transportation, storage and marketing of ethylene and its co-products to continue to qualify as ‘qualifying income’,” despite receiving a positive PLR prior to the IRS releasing its proposed ruling.
As a part of the IRS’s proposed rule, companies like WLKP would have a grandfather period of ten years to continue operating as a MLP. During that time, the partnership will either have to find a way to qualify under the new rule, or lose its status as a MLP at the end of the grace period.
Differing points of view: “Clear as Mud” vs. “Absolute Clarity”
How much clarity the proposed rule actual offers for MLPs depends on who you ask. Senior Analyst Ethan Bellamy of Robert W. Baird & Co. told OAG360® the new regulations are “clear as mud,” while Maria Halmo, Director of Research of Alerian, the company responsible for the Alerian MLP Index (AMZ), took the opposite view.
Halmo told OAG360® the proposed rule “absolutely” offered the clarity that was lacking when the IRS initiated the PLR pause in April, 2014. “Previously, the only guidance available was the law itself in combination with [PLRs]. As PLRs are specific to certain companies and often contained redacted sections, they can be difficult to interpret and generalize.” Halmo went on to say that the very specific way in which qualifying activities are described would go a long way in understanding what would meet requirements moving forward.
Bellamy said the proposed ruling had requirements that made little sense. “The water rules, in particular, are illogical,” he said. “From a risk management standpoint, no MLP can afford to avoid spending time and resources trying to help the IRS clarify this guidance… The only thing [the proposed ruling] clarifies is that billable hours at law firms handling MLP qualification issues are headed up.”
It’s important to remember that this is only a proposed rule and not a final version yet, says Halmo. When asked if there might be any changes to the final version, Halmo said Alerian expects the final version to be largely the same in intention, but that it will likely include even further detail and specifications about what activities will generate “qualifying income.”
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