The Internal Revenue Service (IRS) has been encouraging oil and gas spinoffs to a great extent, says Victor Fleischer, a professor at the University of Colorado Law School. He says the roots of this story go back to 1986 when a tax legislation was passed that allowed higher corporate and capital gains taxes, but lower taxes on ordinary income.

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Then there were master limited partnerships, or MLPs. These were publicly traded entities, just like corporations. But under state law, they were formed as partnerships, so they could avoid paying higher corporate taxes. Now Congress had to protect the integrity of its corporate tax regulation. So, it passed section 7704, that made it compulsory for all publicly traded entities to pay high corporate taxes irrespective of how they are organized under the state law. But this rule too had an exception for energy MLPs. That means paying corporate tax was optional for energy MLPs.

Effective Lobbying

These days, a large number of energy companies are being organized as partnerships. So, MLP unit holders are taxed at individual rates rather than a corporate rate. The legislation states that “special considerations apply”, which Victor Fleischer considers as a code for “effective lobbying.”

Initially, MLPs were nothing more than passive vehicles that delivered a steady stream of income to investors. But now they have turned into growth companies. Firms like Kinder Morgan Energy Partners now promise capital appreciation, not just a steady stream of income. In fact, MLPs resemble normal corporations. So, the tax loophole is like a direct tax subsidy to such firms.

New Private Rulings of IRS

Over the past few years, IRS has been very lenient as to what constitutes as an energy MLP. That resulted into more companies legally avoiding the rule that all publicly traded entities should pay corporate tax. A number of private rulings by IRS have made it extremely easy for oil and gas giants to spin off their midstream assets into separate entities that operate as MLPs.

Those rulings prompted integrated oil and gas companies like Marathon Oil Corporation (NYSE:MRO), Murphy Oil Corporation (NYSE:MUR) and ConocoPhillips (NYSE:COP) to disintegrate their businesses.

IRS is unlikely to work on that loophole. Effective lobbying at work.