IRS Draws Lines for MLPs

Publication February 15, 2017

Master Limited Partnerships must adapt to new guidelines.

The IRS settled in January what types of minerals and natural resources businesses may operate as master limited partnerships or MLPs.

Companies that are operating currently as MLPs, but will not be able to do so in the future, will have 10 years to adjust.

The guidelines are in the form of final regulations. They interpret section 7704(d)(1)(E) of the US tax code. They were published on January 24, four days after White House chief of staff Reince Priebus sent a memorandum to all federal agencies imposing a freeze on any new regulations that had not been published yet in the Federal Register.

An MLP is a partnership whose ownership interests are traded on a stock exchange or secondary market. The United States usually taxes publicly-traded companies as corporations. However, it makes an exception for partnerships that receive at least 90% of their gross income each year from passive sources, like interest or dividends, or from activities tied to minerals or natural resources. Such companies are able to operate without having to pay corporate income taxes. Their income is taxed to the owners directly.

The regulations explain how closely tied a partnership’s activities must be to minerals or natural resources to produce good income.

The IRS had been fielding a growing number of requests for private letter rulings from companies that provide services to the oil and gas trade and want to operate as MLPs. It put a hold on any further rulings in February 2014 while it evaluated where to draw the line. For example, is a business that sends catering trucks to sell meals to workers at gas fracturing sites closely enough related to production of natural gas to be able to operate as an MLP? The agency lifted the hold in early March 2015 and said that regulations would follow.

The regulations treat income as qualifying income only if it is from engaging directly in “exploration, development, mining or production, processing or refining, transportation or marketing” of minerals or natural resources or from providing a limited class of services to companies that are directly engaged in such activities.

The eight direct activities represent various stages from extraction of minerals and natural resources through eventually offering of them for sale. Converting minerals or natural resources into something else through “manufacturing” goes too far.

The vast majority of comments the IRS received after proposing where to draw lines in 2015 addressed what should qualify as “processing” or “refining.”

“Processing” may cause a substantial physical or chemical change. However, coking of coal or activated carbon does not qualify. These are manufacturing processes that create a new product rather than mere processing. The regulations include a list of 35 qualifying products that may be produced by refineries and still be considered “processing.” The list came from the US Energy Information Administration.

“Transportation” — another permitted MLP activity — means doing the physical work of moving oil, gas or other minerals or natural resources by pipeline or marine vessel.

Liquefying natural gas to produce LNG, or regasifying it to turn it back into natural gas, qualifies as a transportation activity.

Producing ethanol or biodiesel does not qualify since they are not produced from depletable minerals or natural resources. However, an MLP can act as a blender of ethanol or biodiesel with gasoline or other transportation fuels without being considered to have moved too far downstream as long as the ethanol or biodiesel is not more than 20% of the total volume of the blended fuels. There is a limit of less than 5% by volume on an MLP adding other items to natural gas or oil products.

In general, any activity that involves retail sales or distribution to retail sellers or end users goes too far. Thus, for example, supplying gasoline to service stations does not qualify. However, there are exceptions for certain bulk and wholesale sales to end users, such as supplying fuel to electric utilities. A special provision allows an MLP to supply liquefied petroleum gas, or LPG, directly to consumers.

An MLP can hold passive interests in minerals. Examples are royalty interests, profits interests, rights to production payments, delay rental payments and lease bonus payments.

A number of paper companies had been considering converting parts of their operations into MLPs. The regulations make clear that converting timber into wood chips, sawdust, untreated lumber, veneers (without any substances added), wood pellets, wood bark and rough poles is an acceptable activity for an MLP. However, it goes too far to produce pulp (at least if chemicals are added), paper, paper products, treated lumber, oriented strand board, plywood or treated poles.

The IRS said making plastics and similar petroleum derivatives is not a qualifying activity. At least two chemical companies are using MLPs to own facilities that convert ethane and propane into olefins that are used to make plastics after receiving private rulings from the IRS in 2012 and 2013 that such businesses qualify. The regulations allow them to continue. The regulations do not differentiate between olefins made from natural gas and crude oil. However, methanol is not on the EIA list of refinery products, so it is not a qualified product.

Services to minerals and natural resources businesses qualify only if they pass three tests.

The services must be specialized, essential and significant to the direct activity being undertaken by the minerals or natural resources company. The IRS said the tests are intended to “differentiate between mere provision of general services, goods, or equipment to others and active support” of a qualifying activity.

Services are “specialized” if the workers who perform them require special training unique to minerals or natural resources industries. If the company is providing property, then the property must be of limited use outside the direct activity and not be easily converted to another use. An MLP can provide injectants, like water or lubricants, for use in fracturing, provided it collects the injectants after use and cleans, recycles or otherwise disposes of them as required by law.

Services are “essential” if they are necessary physically to complete the direct activity or to comply with federal, state or local law regulating the direct activity. An example is water delivery and disposal to a gas fracturing site. Legal, financial, consulting, insurance and similar services are not considered essential.

To be considered “significant,” the services must require partnership employees to be an “ongoing or frequent presence at the site” and the employees must be doing something that is necessary for the direct activity. The IRS said the work can also be offsite provided the services are offered exclusively to companies engaged in qualifying activities. An example is offsite monitoring. The employees can work for affiliates or subcontractors as long as they are being compensated by the MLP.

Renewable energy companies have been lobbying Congress since 2004 for the ability to operate as MLPs. They are not able to do so currently, mainly because their income does not come from “minerals or natural resources.” Energy sources like the sun or wind are not natural resources because they are inexhaustible. The phrase refers only to things that deplete.

A company that produces geothermal steam or fluid can operate as an MLP, but owning a power plant would take the MLP too far downstream from a pure minerals or natural resources business.

The new regulations apply to income earned on or after January 19, 2017. Most companies already operating as MLPs will have 10 years through January 19, 2027 to adjust to the new rules. This transition relief will be given to any existing MLP that, before May 6, 2015, had a private letter ruling, treating as a qualifying activity, an activity that the IRS regulations now treat as ineligible or that was treating an activity as qualifying under a reasonable interpretation of the US tax code. Merely having a “reasonable basis” for a position is not good enough.

The IRS said the fact that a partnership terminates for tax purposes during the 10 years will not cut the transition period short. A partnership terminates for tax purposes if there is a transfer of 50% or more of the profits and capital interests in the partnership within a 12-month period.


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