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Primer for prospective investors in Kinder Morgan Energy Partners, L.P. and Kinder Morgan Management, LLC

Prologue

There have been many excellent articles and accompanying comments written about these Kinder Morgan entities. However, most of these delve into the economics and tax effect of owning them together with analyses of the future prospects of each. To those investors who have not had the time to do basic background research of these entities, such articles and comments can be bewildering.

Even those who have already invested in these companies often find that there are many aspects of the companies they either never understood or of which they were not aware. Unfortunately , some of the articles and comments that do touch on the basics of these companies are either incomplete, misleading or just plain incorrect. A common complaint I have seen is that either the writing was difficult to follow or used terminology that was confusing and inconsistent.

While I have tried to keep it simple and accurate, I am far from perfect and I am sure that there will be many who will point out errors or improvements to what I have written. I have no qualms about that but I ask that comments be kept to the subject and not digress into areas that have been covered in the articles noted above.

In order to achieve my objective, I have skipped over many details in the body of this article and have written endnotes (1) where I thought some readers might want to know more detail and (2) where I felt sourcing was important. The reader should, however, be able read just the main part and get the background he or she needs.

Background: Entity Types

The following describes the main elements of the types of entities that are involved with the companies under discussion.

MLP - Master Limited Partnership

MLPs are partnerships that have their limited partnership units listed for sale on stock exchanges. Limited partners are those whose liability for partnership debts, etc. are limited to the extent of their capital account. Their capital account is credited for the purchase price of their units and increases by their share of the partnership profits. It is decreased for distributions which are normally in the form of cash.1

Under the current tax code the general rule is that public partnerships are taxed as if they were corporations. That is, the corporation pays income tax on its earnings and passes the leftover earnings to its stockholders as dividends, which are then taxed as income to the stockholder. However, there are several exceptions to the rule and one of these is for certain MLPs.

What qualifies a MLP? It must receive 90% of its revenues from qualified sources . What are qualified sources? One source is revenue from certain aspects of the oil and gas industry. Transportation, which includes pipelines, are included2

Kinder Morgan Partnership (NYSE:KMP) is an MLP that qualifies to be taxed as a partnership.

LLC - Limited Liability company

LLCs' are companies that can be organized as partnerships or corporations with one common attribute being that the owners have limited liability for the debts of the company. For tax purposes, they are normally treated as a partnership which means the LLC pays no income tax and the income "flows through" the company just like a partnership and the income is taxed at the stockholder's level.

However, the LLC can elect to be taxed as a corporation.3

Kinder Morgan Management (NYSE:KMR) is an LLC that has elected to be taxed as a corporation.

Definitions Used

It is common, in other articles and comments, to see the same term used to have more than one meaning and some meanings used for more than one term. For the sake of clarity. the following terms have the following meanings within this article:

In connection with KMP, owners are limited partners and are referred to as "Unitholders" who own "Units" in a limited partnership. KMP makes quarterly disbursements in cash or special units ("I-Units") called "Distributions."

In the case of KMR, the owners are "Shareholders" who own "Shares" of stock and who receive quarterly distributions in the form of KMR stock ("Stock Dividends").

Entity Histories

In 1997 Richard Kinder and William Morgan invested in a small public company and using the MLP format, made acquisitions and did development to make KMP one of the largest pipeline companies.

In 1999 they took over a small but important company and went public as KMI, Inc (NYSE:KMI).4

In 2001, KMR was formed as a publicly traded company to entice institutional investors to invest in the company. Most institutions did not want to get involved in partnerships and the extra paperwork involved.

In 2011 they acquired El Paso Corporation and in so doing the Kinder Morgan enterprises became the largest group of midstream5 companies and the 3rd largest energy company in North America. A fourth public company, El Paso Pipeline Partners, a limited partnership (NYSE:EPB) was also formed.

KMI, Inc. owns the General Partner of KMP and EPB. Neither KMI nor EPB are discussed further in this article.

The KMP and KMR Relationship

KMP has three types of limited partner units. The first are referred to as Common Units and are the units that are sold directly to investors. Quarterly distributions to Common Unitowners are made in cash.

The second type consist of Class B Units which are owned by some of the company's management. They are identical to the Common Units except that they are not eligible for trading on the New York Stock Exchange. Distributions to the Class B Unit owners are made in cash

The third type of Units are called I-Units and are used solely in connection with KMR. In connection with the initial offering by KMR, funds received from the sales of KMR stock were used by KMR to simultaneously purchase an I-Unit from KMP. These I-Units are the only significant asset of KMR. Quarterly distributions to KMR are made in the form of additional I-Units in an amount that basically equals the quarterly cash distributed to the Common Unitholders. In turn, KMR declares stock dividends to its stockholders using the same formula used in determining the number of I-Units that KMR receives from KMP.6 As a result, the number of KMR shares owned by its stockholders always equals the number of I-Units owned by KMR.

KMR has no significant business purpose other than to be a vehicle for institutional investors to effectively participate in KMR without having the paperwork and tax consequences that would result if they owned KMP units directly.7 KMR is KMP's shadow; if you own a share of KMR you effectively own a unit of KMP.

Pipeline and storage facilities are capital intensive and together with KMP's penchant for making acquisitions of companies such as El Paso, they require large amounts of debt and capital. KMP has made several public unit offerings over the years for expansion. Such offerings tend to be dilutive in nature but due to management's stewardship have, in the long run, resulted in added value for all units.

KMR has also had additional public stock offerings, the proceeds of which are used to benefit KMP. The mechanism for this is for KMR to sell stock in itself and use the proceeds to purchase the equivalent number of I-Units from KMP. Since the I-Units have full value and are issued immediately to KMR, there is little or no dilution to KMR stockholders.

Investor Tax Situations

While the taxation of both KMP and KMR investors have been thoroughly discussed in other articles, it is still helpful to summarize them here. Let it suffice to say that the matter of taxes plays an important part in determining which entity to purchase and what type of account--- taxable, tax exempt or tax-deferred---to use. Again, most of the articles on Kinder Morgan cover these areas in detail.

Potential investors would be wise to touch base with their tax advisors prior to investing.

KMP: There are no income taxes payable at the partnership level; instead proportional amounts of various taxable items (i.e. ordinary income, capital gains) are reported to investors on IRS Schedule K-1 for use by the Unitowners in preparing their returns. In other words, the income is "passed through" from the partnership to the partners. Unitowners are not taxed on their cash quarterly distributions8; instead, at the end of each year, the Unitholder's K-1 will show what income to report. It will also show the status of the partner's capital account. Purchases of Units and the partner's share of partnership income are credited to the account and distributions received are deducted from the account. The annual ending value becomes the basis for determining the gain or loss upon sale of the units.9

KMR: Having elected to be taxed as a C-Corp10 KMR would normally pay income taxes. However, the company has little taxable income because under the partnership agreement no income is credited to the I-Units it owns. It is only at the liquidation of KMP that income would be credited to the I-Units.11 (Incidentally, it is only upon such liquidation that KMR would receive any cash in lieu of I-Units from KMP which in turn would be paid to KMR stockholders.)

Epilogue

There seem to be only on or two other MLP entities using a corporate shadow. This is surprising on many counts, such as the difference in taxation of investors and the attracting of institutional investors, all of which provide versatility in financing.

Much of the material contained in this article was gleaned from the Kinder Morgan web site and/or their published annual reports or their other public documents. I have tried to footnote any material that was taken substantially word for word from these records.

Footnotes

1 These distributions are normally referred to as "Return of Capital". The distributions lower the balance of your capital account . The capital account balance parallels the investment's basis for determining gain or loss.

2 See tax code 26 USC 7704 A common misconception is that the MLP must payout its income to qualify. In the case of KMP, it is the partnership agreement that requires distribution of cash to all units except for I-Units;

3 See IRS Publication 3402

4 In 2006 Mr. Kinder and others took KMI private. In 2011, KMI again went public.

5 Pipeline companies are considered "midstream" because they fit between the producers of the product ("upstream") and the users of the product ("downstream"). These terms were developed to describe the oil industry whereby the exploration and drilling for oil are upstream and the refineries and other end users are downstream.

6 The formula for determining the number of I-Units to issue to KMR is determined as follows: The amount of the cash distribution made to Common Units is divided by the closing price of KMR shares averaged over the last ten trading days preceding the NYSE ex-dividend date. The resulting fraction is then multiplied by the number of I-Units held by KMR to determine how many I-Units should be given to KMR.

KMR uses the exact same formula to determine how many additional KMR shares go to each shareholder for their quarterly dividend.

It should be noted that KMR shares have historically traded at a discount to the KMP Unit prices. Since the cash paid out to KMP unit holders and the value of the shares given to KMR shareholders is almost exactly the same, the resulting yield on KMR shares is higher than on KMP units. There is no logical explanation for why KMR shares are lower priced.

7 Although KMI owns the General Partner of KMP, it has assigned the responsibilities of a GP to KMR to the extent permitted by law and the KMP partnership agreement. I am not aware of the reason for this arrangement.

8 As previously noted, such cash distributions are considered to be Return of Capital, not income and therefore not taxable.

9 This brings up one of the most confusing aspects of oil and gas company taxation--"Recapture". The IRS allows the partners to deduct their share of depreciation and depletion expenses when reporting the annual income. This means that the partner is saving taxes at the ordinary income tax rates each year. Upon sale of units, a portion of the capital gain is taxed at ordinary income tax rates due to the "recapture" of depreciation and depletion that was previously deducted. The balance of the gain, if any, is taxed at capital gain rates. The IRS reasoning is that you shouldn't be able to use ordinary income tax rates when you use the deduction and the lower capital gains tax rate when you sell.

10 A C-Corp is any corporation where the entity is subject to Federal Income Taxes as opposed to a partnership whereby income is passed through to the partners. Most corporations are C-Corps although the IRS recognizes S-Corps which are legally corporations but taxed as a partnership. The S-Corp designation is derived from the fact that it is Subchapter S of the IRC that defines the requirements necessary before a company can elect to be a S-Corp.

11 See Page 45 of KMP's Form 10-K for 2012 .

Disclaimer: I am not a registered investment advisor and nothing in this article should be construed as a recommendation to buy or not buy securities of the entities mentioned. The material is provided for background information only.

Source: Investors' Primer For Kinder Morgan