- The nuts and bolts of what will happen to your KM holdings taxwise in the reorganization.
- Those who invested in KMR, especially in a Roth IRA, are in the best shape, along with KMI investors.
- Those holding KMP in a regular account will be hit with ordinary tax rates on some or even all their gains due to Recapture.
- Those in tax-advantaged accounts will be hit with UBTI in lieu of the Recapture problem.
- In no case will anyone pay Federal Income Tax on more than the amount of their sale, since your tax basis cannot be below zero.
Taxation Fundamentals for the KM Reorganization of Kinder Morgan, Inc., Kinder Morgan Management, LLC, Kinder Morgan Energy Partners, LP and El Paso Pipeline Partners, LP
There have been many articles written about the reorganization of the Kinder Morgan companies, but none have laid out the tax consequences for the unitholders and shareholders of the organizations being acquired. However, the comments on these articles almost always drift into a discussion on the taxation that will be involved. These comments fall into two main groups: those comments which ask for information about the taxation of their holdings, and those comments which offer information (often incomplete or incorrect information).
As I did in my article "Running the Kinder Morgan Obstacle Race", which can be found here, I will attempt to clearly state the taxation that will be involved for each company. In fact, I strongly advise you to read or re-read that article. Much about what is written there is applicable here, and in some ways, is easier to understand. Note that the taxation in El Paso Pipeline Partners (NYSE:EPB) is the same as what is involved for KMP. Therefore, the discussion below for KMP applies to EPB.
Also note the following:
1. The information provided is based on what is known about the reorganization as of this date. Details as to which portions of the IRS tax code will be used are not known. Statements of KM personnel have been that the KMP and EPB transactions will result in a taxable transaction for their unitholders, whereas the KMR transaction will result in a tax-free transaction for its shareholders.
2. I will not reply to comments which ask me about a specific situation unless I think it is of interest to the majority of readers, nor will I compute the taxes for anyone or tell how to fill in specific forms, etc. That's what advisors get paid for.
Kinder Morgan, Inc. (NYSE:KMI)
Let's start with an easy one. There is no tax effect on these stockholders, nor will the tax basis of the shares they own change.
Kinder Morgan Management, LLC (NYSE:KMR)
These shareholders will have no taxes to pay as a part of this merger. This is not a taxable sale of their shares, so there are no capital gains on which to pay tax.
The tax basis of their holdings will not change in total. However, the tax basis per share of KMI will be the pre-merger total basis divided by the number of KMI shares received.
Example: You own 110 shares of KMR. You paid $50 per share for 100 shares, and received 10 shares as stock dividends. Your tax basis is $50 X 100, or $5,000. Your tax basis per share is $5,000 / 110, or $45.45 per share. You will receive 273 shares of KMI. Your total tax basis will be $5,000, and your per KMI share tax basis will be $5,000 / 273 shares, or $18.32.
Note: In all examples, I have rounded dollar amounts to 2 places and have rounded shares to whole shares.
1. If you sell your shares in KMR prior to the merger, you will have a taxable transaction and will have LTCG (Long-Term Capital Gain/Loss). The gain would be the sales dollars received less your total cost of acquiring the shares. Theoretically, the gain would equal the sales value of those shares received as dividends. Practically, there are many other factors at work which hide the above.
2. All of the above assumes you hold your shares in a taxable account. If held in a regular IRA, there is no taxable gain if you participate in the merger, and if you sell beforehand, there is no tax on any profit realized. What will happen is that when those shares (actually the proceeds from selling them) are distributed as part of an RMD, they will be subject to ordinary income rates versus if they were liquidated outside the IRA, they would benefit by the LTCG rates.
If held in a Roth IRA, there would be no tax due at any point, including any distributions the holder may take from the Roth IRA.
3. There is no tax benefit from gifting your shares to people in lower tax brackets, either before or after the merger, as there is no tax to pay. There is no escaping the tax due on distributions from your IRA for RMD or any other distribution.
4. The tax advantage to contributing your shares to charity is that you receive a contribution for the Fair Market Value, FMV, of your shares.
Kinder Morgan Energy Partners (NYSE:KMP)
Now we come to the most complicated of the companies. Please don't forget that everything here also applies to EPB. We need to deal with situations when KMP is held in a taxable account and situations when KMP is held in a tax-advantaged account such as an IRA.
Absolute: Your taxable income for Federal Income Tax can never be greater than the proceeds from your sale or the value received in an exchange.
KMP in a Taxable Account
You have two options: Sell before the reorganization takes place, or go through the reorganization. In either case, the tax result is the same, as the exchange of your units is a taxable event and taxed as if you sold your units. There are circumstances where such a reorganization is non-taxable; at this point, I don't have enough information to know why this transaction is taxable. Kinder Morgan says it is a taxable event, and it certainly isn't in its interest to say that.
If you sell before the reorganization, your tax will be based on the tax basis of your units. The tax basis is determined as follows:
- Start with your ending balance of your capital account, as shown on your the K-1 issued for the year of sale.
- Add the amount that the annual losses reported exceed the amount of annual income reported. (The net of Part III, Line 1 shown on every K-1 for the years owned. These losses in excess of gains were not deductible on your annual tax returns, and are referred to as "passive losses". They are deductible in the year that you sell substantially all of your holdings in the partnership.)
- Add your share of the amount of nonrecourse debt, as shown on the K-1 issued for the year of the sale.
- If the balance at this point is still negative, add back an amount that will bring the total back to zero. (This represents any distributions that do not reduce your basis to below zero, and which were taxed as Capital Gains in the years they occurred.)
The above assumes you are selling substantially all your units. If you are not, then passive losses in excess of profits are not added back to your basis.
If you sell your shares before the reorganization, the sales price is, of course, the price you receive for your units. If you wait for the reorganization, the sales price would be the value of 2.1931 per unit times the price of KMI on that day plus $10.77 per unit. I do not know if that would be the closing price, average price, etc., but that should not make a significant difference.
You can use the same calculation at any time to compare the value of what you would receive in the reorganization if you sold on Day "X", to the value of your Units on Day "X". This may help you decide whether to sell or to wait for the reorganization.
Example: KMI is selling for $40 on Day X: KMP is selling for $90. The reorganization value would be $40 X 2.1931 = $87.72 + $10.77 = $97.49.
There are actually a few more ways of disposing of your KMP units. First, you can donate them to charity. But be aware that your contribution is limited to the value on the day donated less the actual cost you paid. Thus, if you paid $75, the tax basis is $22 and the FMV at the time of donation is $80, your contribution is $5.
You can also make gifts of your units. This is only beneficial when the person receiving the units is in a lower tax bracket than you. The downside is that there is no step-up of basis to current market value when you and your spouse both die. You and your spouse can each gift $14,000 to any number of people without having to fill out a gift tax return. Any amount over $14,000 by any one person to any one person needs to be reported on a gift tax return. The total amount reported on the form will reduce your lifetime Federal estate tax exemption of $5,340,000. (All figures are for 2014.)
KMP in a Tax-Protected Account
In accounts such as a regular IRA and a Roth IRA, you can make the same computations as above, but there is a major difference: There is no tax payable. In the case of a regular IRA, you will eventually pay ordinary income rates on the distributions from the IRA, and in a Roth IRA, you will pay no Federal Income Tax
That is the good news. Now the bad news: UBTI (Unrelated Business Taxable Income). First the not-so-bad part of UBTI. Each year, you receive a K-1 from KMP. If it and any other investments in your IRA report UBTI totaling more than $1,000, the IRA's custodian is supposed to file a report and pay the tax out of the IRA funds. For KMP, it has reported negative UBTI for the past few years, so the chances of having UBTI over $1,000 is small.
Now for the bad news on UBTI. When you have KMP units in an IRA (either regular or Roth), the IRA is investing as a limited partner in an unrelated business enterprise. Since UBIT is charged only on ordinary income from KMP, this not a problem on an annual basis. But when you sell your interest, the "Recapture" process comes into play, and it comes in the form of turning Capital Gain into Ordinary Income.
Note: The effects of "Recapture" is as follows. The Income or Loss reported in Box (1) of Part III of each year's K-1 is after Depreciation and a few other items have been deducted as a cost. Thus Depreciation, etc. has either reduced the Income or increased the Loss and saved you taxes at ordinary income tax rates.
When you go to sell your units, these costs have reduced your tax basis, resulting in higher Capital Gain from the sale. This would result in Depreciation, etc. saving you money at ordinary tax rates each year and costing you taxes at capital gain rates when they were sold. The IRS decided this is not fair, and thus, Recapture was born. Basically it says that since Depreciation, etc. saved you money as ordinary income, an equal amount of the gain upon sale must be Recaptured and taxed at ordinary rates; and only the gain, if any, above that amount will be at Capital Gain rates.
After Recapture, you have a considerable amount of ordinary income which is now subject to UBTI. If you total all your Distributions received and subtract any UBTI previously reported and subtract your $1,000 exemption, you will have the amount of UBTI. This is then taxable at Trust rates, which are as high as 39.6% on income over $11,950. In addition, if the units are held in a regular IRA, the proceeds of a pre-reorganization sale or the eventual sale of KMI shares will be taxed through the RMD of the IRA. Roth IRAs at least will escape this double tax.
You will notice that I have not discussed "Passive Losses". That is because when you sell substantially your entire holding in a passive investment, you may deduct any passive loss carry-forward from that investment, and therefore, past passive losses no longer exist.
Until now, I have tried to stick to pure and clear explanations of what will happen under various circumstances. Now I would like to offer some personal opinions. To those of you who never read any warnings about putting MLPs in a tax-advantaged account, I feel sorry for any UBTI you encounter; for any of those who choose to ignore the many warnings on the basis that you would never sell the units and for anyone who planned to hold the units until death, please remember that "Man plans and God laughs". Don't blame Kinder for spoiling your plans (or perhaps lack of proper planning). There is no way that someone would not suffer in any restructuring of these companies. They were too tied together and dependent on KMP for their income.
Those grumbling about the amount of taxes that will be due have forgotten not only the deferral of taxes they enjoyed, but also the time value of money that applied to those deferred taxes.
And last but not least, this reorganization, or some version of it, was desired by practically everyone just a month or two ago. It cleans up the structure for future financing, and gets rid of the IDRs everybody hated. I, having a substantial part of my retirement funds in KMR in a Roth IRA, will find that it will take a little less time than many others to get my income level back up to where it was at. But I expect that 10 years from now, everybody will have forgotten this restructuring and will be very happy with what they have. Of course, 10 years from now, I will be lucky if I can remember my name!!!
Sec 368 Reorganizations
Sec 512 (C) Computing UBI
Sec 751 Recapture
K-M's K-1 with attached FAQ
Additional disclosure: The author is not a tax expert by training, nor was that his area of expertise. Therefore, and especially because of the complexity of the situation, you are advised to seek the counsel of a tax expert.