The basics of how Federal Income Taxes affect the owners of Kinder Morgan entities
In the article "Primer for Kinder Morgan", I explained the basic structure of each of the three main Kinder Morgan entities, Kinder Morgan Energy Partners (NYSE:KMP), Kinder Morgan Management (NYSE:KMR) and Kinder Morgan, Inc. (NYSE:KMI) and their relationship to each other. There is a fourth Kinder Morgan entity, El Paso Pipeline Partners (NYSE:EPB) which is an MLP formed when KMI purchased El Paso and was only briefly mentioned in my previous article. For this article, the taxation of its unit holders is exactly the same as for the unit holders of KMP.
If you have not read the above article, I suggest you do so prior to reading this article as it established the organizational status of each company.
I could have labeled this article "A primer for Kinder Morgan Taxes" as I have taken pains not to get down to the nitty-gritty of MLP taxes, but instead I am just pointing out the various areas that are involved to give new and prospective investors an idea of what they are getting into when it comes to Federal Income Taxes for the Kinder Morgan companies.
Please note that state income taxes are not covered by this article. In some states, taxes on the various income sources can be significant and are best discussed individually with a tax professional.
Taxation of Dividends and Distributions
This is the easiest of the three entities because it is a C Corporation. The cash dividends declared and paid out by the company are taxable to the shareholder and are eligible for the Qualified Dividend provision.
KMI shareholders receive a 1099-DIV at the end of the calendar year. It will show the amount of dividends and the amount of qualified dividends to enter on their tax returns.
KMR is a LLC which has elected to be taxed as a C Corporation. Thus cash dividends would be subject to Federal Income Taxes. However, KMR, by design, issues only Stock Dividends of its own stock and thus its dividends are not subject to Federal Income taxes. You will not receive a 1099-DIV or any other tax form in connection with these dividends.
The only tax effect these stock dividends have is on the per share tax basis of all the KMR shares you own. The following computation, whether performed by you or your brokerage, may be necessary when it comes to selling any of your KMR shares.
First, assign each purchase of shares to a "lot". Next , as shares are received through dividends, assign them to each lot by multiplying the number of cumulative shares in each lot by the decimal declared by the dividend. Finally, for each lot, divide the total cost of the purchased shares by the total number of shares and partial shares now owned. Your total cost per purchased lot never changes; it is the tax basis per share that decreases.
KMP is a MLP and the first and foremost thing you must keep in mind is that although you purchase these units through a broker or on an exchange, you are not buying stock, you are buying an interest in a partnership and for the most part are subject to how partnership interests are taxed. If you keep this in mind, it may help you see why certain transactions are handled as they are.
I will not attempt to point out the details of MLP taxation. Besides the fact that I don't know every possible situation, much less the correct handling involved, that is what tax professionals get paid for. Make sure you seek one out if you run into such situations.
Every partner in a partnership has a Capital Account ("CA") and the sum of all the partners' Capital Accounts represents the net worth of the partnership.
Your CA in a MPL consists of the following:
1. The money you paid in to purchase a partnership interest. In MLPs you do this by purchasing "Units".
2. Periodic cash distributions paid to you are deducted from your CA. These distributions represent cash that the partnership decides is available to return to the partners and is basically the firm's profit plus non-cash expenses, such as depreciation, minus the cash that is needed to run the business. The money distributed to you is subtracted from your CA.
Note: You will often hear such statements as "80% (or 90%, etc) of your distribution is "tax free". Such statements can be confusing. I think it is better to think that they are simply distributions of cash.
3. Your portion of the firm's income for the period as shown by the company on the K-1 form sent to you at year end. This income is added to your CA. Of course, the MLP may incur a loss for the year. In that case, the loss is deducted from your CA.
If you start with the balance in your CA at the beginning of the year and add or subtract the three above items, you will arrive at your basis at the end of the year. Note that the year's K-1 will show your CA and the amounts added or subtracted as above.
Partnerships, including MLPs, are known as "pass thru" entities for tax purposes. That is, little or no tax is paid by the MLP; the various aspects of income are passed through to the partners via a Form K-1.
Form K-1: This form is prepared by the partnership for each partner. MLPs, as do all partnerships , issue these in lieu of 1099s. As noted above, they include a recap of your CA which is basically your running record of your basis in the partnership.
Also shown on the K-1 are the amounts of various items that need to be reflected in your tax return such as ordinary income, interest, capital gains and losses. Between the directions given on the form and supplemental directions from the MLP, one should be able to complete the job. In subsequent years, after comparing the new year's K-1 to last year's for any code changes, etc., it should just be a case of following the same pattern as the previous year.
Zero or Negative Balance in your CA
Barring the purchase of additional KMP Units which would increase your CA, it is likely your CA will eventually go negative since distributions and your share of losses are usually greater than your share of profits. Any negative balance in your CA (or increase in the negative balance) is taxable as Long Term Capital Gain on your annual tax return.
Loss from Passive Activities
Another small complication with being a limited partner in a MLP is that because you have no active role in the running of the company, it is considered a "passive activity". Any annual losses from a passive activity are not deductible in the year incurred and are not deductible against any income other than income from that particular entity. These passive losses can be carried forward to future years where they can offset gains and can also be used when the entire interest in the entity is sold. If you own a number of MLPs (and /or other limited partnerships), the record keeping can become necessary but somewhat complicated.
Taxation upon sale of Shares or Units
Gains and losses upon sale of any or all shares are computed and handled as Capital Gains and Losses on your tax return consistent with any such sale of corporate stock.
Again, any gains or losses upon sale are handled as Capital Gains and Losses on your tax return. It is here, however, that keeping track of your purchases and assigning additional shares from stock dividends as noted above may pay off if you wish to use any of the specific lot identification cost methods. For instance, you may wish to minimize your gain for the year by selecting lots that have the highest cost basis.
Note that there are no income taxes associated with KMR stock until it is sold and then the gain or loss is treated as a capital gain or loss which usually results in a lower tax rate. The downside of this is that if one needs cash and has to sell some KMR shares, there may be a tax effect as well as a transaction cost.
Here is where it gets difficult. As noted above, your basis for your Units is your CA balance which normally decreases over the years, meaning that even if the Unit price has not increased since you purchased it, you will have a gain. Due to a process known as "recapture", some of the gain will be treated as ordinary income rather than Capital Gain. What is recaptured are items designated by the Internal Revenue Code and includes such items as the portion of the MLP's depreciation that was deducted from income each year. Any gain on sale is ordinary income up to the total amount of the recaptured items; if there is gain still remaining, it is considered Capital Gain. The theory behind "recapture" is that the IRS allows you to deduct such expenses and to deduct them against ordinary income at ordinary income tax rates. The recapture is to prevent one from converting ordinary gain into capital gain. Anyone for simplifying the tax code? The MLP will compute the amount to be recaptured for you and it will give you most of what you need to file for your sale.
If you wish to get educated and confused at the same time, I urge you to review Reel Ken's article on SA, which covers what happens when you sell a MLP such as KMP. While the article is well written and his conclusions easy to follow, it is the accompanying comments that will make you dizzy.
Holding KMP in a Tax advantaged Account versus a Taxable Account
This subject is probably worth its own article. My objective here is not to advise you which type of account is appropriate for each entity but to inform you of the results of such decisions.
In the case of KMI, there is no special difference from holding any other C Corporation in one account or another. The result of placing it in a Roth IRA is that you are not taxed on its dividends (ordinary income tax saved) or at its sale (Capital Gain tax saved). This is also true of a regular IRA except that you are giving up Capital Gain tax rates for Ordinary Income tax rates when distributions are taken from the IRA.
The same is true in the case of KMR except its dividends are not taxed outside of an IRA. This means that you are duplicating some of the tax advantages of an IRA.
This brings us to KMP. There is little difference as to the effect of using a Roth or regular IRA except the normal advantage of a Roth IRA not being subject taxes at any time-- with one exception: Unrelated Business Income (UBI) that gives rise to Unrelated Business Income Tax (UBIT). The IRS considers that owning a partnership interest in an IRA is engaging in business outside the scope of the IRA and thus any income from an MLP is UBI. They do exclude the first $1,000 of any UBI income from the UBIT on a total basis. That is, the $1,000 is not per entity owned. One normally needs to own a considerable amount of MLPs, etc. in an IRA to exceed the $1,000, but it depends on which MLPs are owned.
However, if you sell your MLP, such as KMP, while it is in the IRA, all of your income from the MLP is totaled and considered UBI and tax will be due on the amount in excess of the amount, if any, that has been paid plus $1,000. This, of course, is in addition to the tax payable on funds drawn from a regular IRA. There would be no tax other than the UBIT that would occur if it were in a Roth IRA.
This UBIT is payable by the IRA itself as determined by the custodian. It is my understanding that the amount of compliance on this differs with the various custodians and in particular the tax payable upon sale is not stringently enforced partly due to its complexity. Nevertheless, the possible problem with UBIT is the major reason put forward by many to not hold KMP, or any other MLP, in a tax advantaged account.
This article is primarily based on the following sections of the Internal Revenue Code which are applicable as noted:
305(a) Re: Taxation of Stock Dividends
307(a) Re: Stock basis after Stock Dividends
512(c) Re: Computing UBI
469 Re: Passive Activities
751 Re: Recapture
Last but not least, I would like to thank "Willie119" for his comments and recommendations as a reader reviewing the pre-published article.
Disclaimer: I am not a registered investment advisor nor a tax expert and nothing in this article should be construed as a recommendation to buy or not buy securities of the entities mentioned nor as tax advice to be relied on in specific circumstances. The material is provided for background information only.
Disclosure: I am long KMP, KMR, KMI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.