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On November 2, the House Ways and Means Committee released the Tax Cuts and Jobs Act (the “Act”). The Act is over 400 pages and was accompanied by a section-by-section summary that itself reached 82 pages. The Act is aimed at creating a comprehensive and sweeping reform of the U.S. tax code, and is not focused on master limited partnerships (“MLPs”) in particular. In fact, despite the volume of material released, MLPs are not expressly addressed at any point. However, particular proposals in the Act could have significant effects on MLPs. Below are a summary of certain proposals in the Act which may impact MLPs.
The Act would become effective as of January 1, 2018 if signed into law. However, it is expected that the Act will undergo many modifications in the coming weeks as the House Ways and Means Committee works to get the Act through Congress and lobbying efforts from a variety of interested parties increase. The final legislation could be significantly different from the current draft of the Act. We will continue to provide updates when appropriate to help you keep track of the Act and its potential effect on MLPs as the legislation progresses.
Preservation of IRC Section 7704(c).
The Act does not repeal IRC Section 7704(c), which provides an exception from the general rule that a publicly traded partnership (“PTP”) is classified as a corporation for U.S. federal income tax purposes. IRC Section 7704(c) provides that a PTP is not classified as a corporation if 90% or more of the PTP’s gross income consists of “qualifying income.”
25% Tax Rate for Business Income from Pass-Through Entities.
The Act would allow MLP investors to apply a new lower tax rate to taxable income derived from MLPs. Because MLPs are pass-through entities, MLP income is passed directly through to investors, where it is currently taxed at individual tax rates, the highest of which is 39.6%. The Act would reduce the tax rate for certain business income derived from pass-through entities such as MLPs to 25%. Under the Act, net income derived from a passive business activity would be treated entirely as business income and fully eligible for the 25% rate. Business owners deriving net income through an active business activity (based on current law material participation and activity rules) can either (i) categorize 70% of their income as wages, subject to ordinary rates, and 30% as business income, taxable at the new 25% rate, or (ii) set the ratio of their wage income to business income based on the level of their capital investment. The potential rate reduction with respect to all or a portion of business income derived by MLPs may make MLPs a more attractive investment for a number of investors.
Corporate Tax Rate.
The Act sets a permanent corporate tax rate of 20%, reduced from the current 35%. This could potentially make MLPs less appealing to investors due to the lower corporate tax rate. However, taxable income derived from the operations of an MLP would continue to be subject to one layer of taxation, as opposed to the additional 20% tax that would continue to apply on corporate profits.
Partnership Technical Terminations.
Under current law, a partnership has a “technical termination” if there is a sale or exchange of 50% or more of the total interests of the partnership within a 12-month period. When a technical termination occurs, the business of the partnership continues in the same legal form; however the partnership is treated as newly formed and must make new elections for accounting methods, depreciation lives, etc. The Act repeals this rule. A partnership would be treated as continuing even if more than 50% of the interests of the partnership are sold or exchanged, thus new elections would not be required or permitted. Since MLP units are traded, MLPs run the risk that a technical termination may occur outside of their control. A repeal of the technical termination rule would benefit MLPs by alleviating this risk and would allow more flexibility for MLPs when undertaking various restructurings or reorganizations.
Limitation of Interest Deduction.
Under current law, business interest is generally allowed as a deduction in the year in which the interest is paid or accrued. The Act would cap interest deductions at 30% of a company’s “adjusted taxable income” which is taxable income without regard to interest expense, interest income, NOLs, depreciation, amortization and depletion. The net interest expense disallowance would be determined at the partnership rather than the partner level.
Changes to Depreciation Deductions.
Under the Act, taxpayers would be able to fully and immediately expense 100% of the cost of qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. Qualified property includes tangible personal property with a recovery period of 20 years or less under the modified accelerated cost recovery system (“MACRS”), certain off-the-shelf computer software, water utility property, and qualified improvement property, but specifically excludes any property used by a regulated public utility company or any property used in a real property trade or business. The Act also expands the definition of qualified property from its definition under current law by repealing the requirement that the original use of the property begin with the taxpayer; instead, property is qualified if it is the taxpayer’s first use.