Kinder Morgan Management, LLC: The Wise Choice

May.20.14 | About: Kinder Morgan, (KMI)


The tendency now is to invest in Kinder Morgan, Inc. rather than Kinder Morgan Energy Partners.

The decision always seems to be between those two, but there is a third entity that should be considered.

Kinder Morgan Management LLC is a better investment choice.

Lately there have been several articles supporting the purchase of either Kinder Morgan, Inc. (NYSE:KMI), the General Partner, over Kinder Morgan Partnership, the Limited Partnership that is the Limited Partners and an MLP. There have also been a few taking the opposite stance.

But few of the articles even mention Kinder Morgan Management, LLC. (NYSE:KMR) which is a company that "shadows" KMP. Briefly, KMR is organized as a Limited Liability Company and has elected to be taxed as if it were a "C" corporation. When a share of KMR is sold to the public, the proceeds are used to purchase a special unit of KMP called an I-Unit. These I-Units are sold only to KMR. When KMP declares a distribution, it is paid in I-Units to KMR. KMR then declares a stock dividend of its own stock equal to the number of I-Units it receives.

As you can see, the result is that for each share of KMR sold or issued, it is backed by a share (an I-Unit) of KMP. It thus shadow's KMP.

The parallel use of issuing units and shares as dividends has several ramifications, the principal one being that cash is conserved by both companies. However we are concerned here with the effect on KMR shareholders.

Tax Situation Comparisons

Let's discuss KMR. First, there is no Federal Income Tax on the shares received as dividends from KMR. The only effect is to decrease the per share tax basis of each of your existing shares---the total cost of the purchased shares is now divided by the sum of the purchased shares plus the shares received as a dividend. Since the dividends are not taxable, there is no 1099 issued nor is a K-1 since it is not treated as a partnership.

Second, the only Federal Income Tax payable is the tax on any gain from the sale of any of the shares. The gain is a capital gain and subject to the usually lower capital gains tax. The gains are long term if the shares purchased are held more than a year. Note that the holding period of the shares received as dividends have the same holding period as the purchased shares. This means that if you purchase several lots of KMR, you need to keep track of the dividend shares received on each lot. Normally the broker does this for you.

If you sell the shares while in a tax advantaged plan, there is no gain or loss recognized. Unlike KMP units, there is no UBTI issue. If you sell the shares outside such a plan, you will likely have a capital gain because your cost basis has been reduced by all the stock dividends received.

A question often comes up as, "What happens if I hold the shares till I die?" If you are holding the shares in a tax advantaged plan, the shares are passed on as part of the plan without any tax effect. If the shares are held outside such a plan, they receive a step-up to the value at the date of death or the value six months after death, as elected by the estate. At that point you have paid no FIT on any of the shares purchased or received as dividends.

In regard to the tax picture at KMP, you receive and have to deal with a K-1. The distributions received are deemed to be return of capital by the IRS. They are charged against your capital account which account approximates your tax basis (though there are some important differences). Credited to your capital account are your share of the partnership earnings and basically that is what is subject to annual income tax. When your tax basis reaches zero, future distributions are taxed as capital gains. KMP held inside a tax advantaged account is subject to UBIT which can be significant if sold while in the tax advantaged account. KMP held outside such an account is subject to recovery rules which can convert significant amounts of gain from capital gain to ordinary income. Tax-wise, KMP can be a monster of problems and extra work. For more explanation, please see here.

KMI taxes are normally simple--your dividends are taxable and gains on sales are capital gains in taxable accounts. There is no tax involved in a sale within a tax advantaged account.

There is no doubt that KMR is a superior investment, tax-wise, than KMP and has a significant edge over KMI due to KMR's dividends being tax deferred.

The important point, however, is not about the tax results but rather the investment values.

Return Comparisons

Such metrics as the rate of growth and dividend or distribution increases are projections and as such are subject to frequent change. As of the date of this article KMI's annualized dividend is 5.1%. KMP's is 7.4%. KMR shareholders receive the same amount of dividends as KMP, but in stock rather than in cash. KMR's return is 7.8%. The reason that KMR's return is higher than KMP's is that it sells at a discount to KMP and has done so almost all of its history.

If we do look at those factors that are future projections, we find that KM says that KMI will grow much faster than KMP (and thus also faster than KMR). This will allow KMI to catch up and probably surpass KMP in the long run--some 10 to 20 years and that is assuming nothing occurs during that period to change the projections. That is one huge assumption.

All considered, KMR not only has the best return now but probably also in the future if it continues to selling at a discount to KMP as it has in the past.

Cash flow source

KMP has the responsibility under its partnership agreement to distribute its cash flow to the fullest extent. KMI is a major beneficiary of this by dint of its IDR and the KMP Units owned. Other than some minor income from EPB and other owned assets, KMI's growth is tied to KMP's performance. And KMR, being KMP's shadow, does as well as KMP or even better.


The bottom line is that both KMI and KMR are almost completely dependent on KMP's performance for the near future.

However, as long as KMR continues to sell at a discount to KMP, it has the edge in return percentage. KMR has a clear advantage, when it comes to Federal Income Taxes, over KMI and especially over KMP.

I do not understand why anyone would invest in KMP rather than KMR and that would be true even if KMR started selling at a small premium to KMP. It has all the advantages of KMP and none of its disadvantages.

If you want to bet on the future acquisitions that KMI might make, that is fine. But as of now and the near future, KMR will have a superior return.

Disclosure: I am long KMI, KMP, KMR. 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.

Additional disclosure: This article expresses my personal opinion and is not to be taken as professional advice. Always do your own research before any investing.