MLP Parity Act: A Game-Changer?

06/06/2013 6:15 am EST

Focus: MLPS

Maybe not, but everyone deserves equal tax treatment, says Robert Rapier of Personal Finance, who explains some of the implications of the proposal.

Master limited partnerships (MLPs) are a popular investment, and now Congress wants to use them to encourage investment in renewable energy projects. Less has been said about how such newfangled MLPs might work out for investors. And therein lies the problem.

MLP rules state that at least 90% of an MLP's income must come from qualified sources, such as real estate or natural resources. Qualifying energy sources must be depletable resources or their derivatives, such as crude oil, petroleum products, natural gas, and coal.

The main investment attraction of an MLP is that MLPs don't pay corporate income tax. Profits are passed directly to unitholders via (usually) quarterly distributions—unlike corporations, whose profits are taxed first at the corporate level, and then a second time as personal income tax on dividends. In contrast, MLP distributions are taxed just once, at the individual level.

Most of the distribution—typically 80 to 90%—is classified as a return of capital under the depreciation allowance. That lowers the immediate tax bill, but also the cost basis of the MLP investment, resulting in a larger capital gain when the MLP is sold.

Over time, the tax-deferred income can be invested elsewhere, allowing investors to compound returns that would have otherwise been taxed while also earning a steady stream of income. This has made MLPs an extremely popular income investment.

There are more than 100 publicly traded MLPs representing some $445 billion in capital. Approximately $400 billion has gone into qualifying energy and natural resource projects, and about 80% into midstream projects such as oil and gas pipelines.

Current MLP rules exclude ventures in renewable energy, and many renewables advocates have long complained that gives fossil fuels an unfair advantage. So Sen. Chris Coons (D-DE) has introduced the MLP Parity Act, which would expand the definition of "qualified" sources to projects involving wind and solar power, as well as closed and open loop biomass, geothermal, municipal solid waste, hydropower, marine, fuel cells, and combined heat and power (CHP).

It would include biofuels such as cellulosic fuels, ethanol, biodiesel, and algae-based fuels. Energy-efficient buildings, energy storage, carbon capture and storage (CCS), renewable chemicals, and waste-heat-to-power technologies would also qualify.

A number of renewable energy advocates have written articles proclaiming the MLP Parity Act a potential game-changer for renewable energy. I disagree.

MLPs have been successful because of their concentration on energy infrastructure, a booming industry with a long history of strong profitability. However, the vast majority of renewable energy companies exist as a result of mandates at the federal or state level. If certain tax credits and mandates were eliminated, the industry would be decimated, because for the most part it isn't competitive with fossil fuels.

Pipeline MLPs have a steady source of income from which to pay distributions. Where are advanced biofuel companies going to come up with the money for distributions? From added debt? From issuing more units?

Unless they can come up with long-term supply agreements that will see them through even if government support disappears, renewable energy MLPs could prove very risky investments.

The MLP Parity Act enjoys bipartisan support in both houses of Congress, and so has a good chance of becoming law. And despite my skepticism that it will be a game-changer, I support passage of the bill. All forms of energy, whether fossil-based or renewable-and arguably all business activities in general-deserve a level playing field on taxes.

It's just that I won't be recommending renewable MLPs until they demonstrate that they can consistently do what pipeline MLPs have done for their investors.

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