After the market’s big reaction to the news that Kinder Morgan Inc (NYSE:KMI) would consolidate the master limited partnerships (MLPs) that it spun off years ago, you could be forgiven for wondering why so many people were excited to see Kinder Morgan give up tax benefits.
“If the only difference between pass-through entities and taxable entities were on taxes, the assessment that mattered for value would be whether you paid more or less in taxes with one form over the other,” explains NYU Stern School of Business professor Aswath Damodaran. “However, the laws that created the pass-through entities also created restrictions on other aspects of business behavior including where and how these businesses invest, how much they have to pay out in dividends and how they finance their operations.”
Pass-through structure makes more sense for low-growth industries
In addition to being restricted only to certain kinds of business, both REITs and MLPs have to pay out at least 90% of their income as dividends, and they don’t get any tax benefit from taking on debt. Damodaran explains that for a mature industry with low expectations for future growth these restrictions don’t really matter, and could even protect investors from wasteful investments. But if you’re in a high growth industry, investors potentially have more to gain when corporations can reinvest their income or use leverage (with tax benefits intact) to finance M&A activity or capex spending. This depends on skilled management pulling it all together, but there’s a higher upside even with the extra taxation.
In the case of Kinder Morgan, what had been a mature business, the US energy sector, is now growing rapidly thanks to shale. Consolidating its MLPs will allow Kinder Morgan to use their income to acquire other companies in a sector the market is already very bullish towards. Anyone who was invested in the MLPS is about to get hit with a tax bill they hadn’t planned for, but otherwise the switch to a consolidated structure makes great sense.
MLPs, REITs aren’t always the better choice from a tax perspective
But it turns out that even if you ignore the difference between high and low growth industries, it’s not completely obvious which tax treatment is better for investors. Post-personal tax income depends on the difference in corporate tax rates and personal income, capital gains, and dividend taxes, which means that a corporation considering the two different structures also has to consider the composition of its investor base (and the taxes they pay) when trying to maximize shareholder returns.
In a low-growth industry, the pass-through structure is often a better deal for high income investors, but even with double taxation that isn’t always the case.