Investing in the Kinder Morgan-El Paso Deal By Jonathan Noble March 25, 2012 Introduction Kinder Morgan, Inc.

(KMI) and El Paso Corp. (EP) recently agreed to a merger.1 If the deal closes, the combined company will become North Americas largest natural gas transporter and fourth largest energy company. The deal is structured to benefit from the companies unique tax advantages. This article will describe those advantages and then propose strategies for investors to make the most of them. The Anatomy of a Master Limited Partnership Taxes play a large and ever-increasing role in the choice of business entity for companies engaged in natural resources. These companies benefit from a special rule in the Code that allows them to avoid corporate taxation yet act like corporations.2 Instead of organizing as corporations, these companies have mainly organized as large partnerships called master limited partnerships (MLPs). MLPs are unique business entities that can issue easily tradable partnership interests (units) on established markets while avoiding the corporate tax regime.3 The Code treats most large corporations as distinct entities for tax purposes. As distinct entities, they are subject to two levels of tax on their income: one at the corporate level, and another at the shareholder level when earnings are distributed to shareholders as dividends.4 By contrast, the income of partnerships is subject to a single tax; the income and losses pass through the entity and are included (or deducted) directly by the partners of the business.5 The partners must report their distributable share of the partnerships income on their individual tax returns. This pass-through treatment is an attractive feature of the partnership form. So attractive, in fact, that many companies chose to form partnerships in the late 1980s to escape the double tax regime of Subchapter C.6 The emergence of large partnerships rivaling the size of traditional, publicly-traded corporations but paying no corporate taxes caught the attention of Congress. Perhaps these partnerships will erode the corporate tax base? members of Congress

worried.7 Congress responded by classifying publicly-traded partnerships like MLPs as corporations for federal income tax purposes.8 But Congress exempted partnerships primarily engaged in specific business activities, which include many natural resource-related activities like transporting gas, oil or products thereof.9 Thus the Code permits many energy companies to continue to operate as MLPs yet avoid double taxation. Since then, many energy companies have structured themselves to take advantage of the partnership form. Kinder Morgan is a prime example. Though its a corporation subject to double taxation, KMI contributed most of its $18 billion in income-generating assets to Kinder Morgan Energy Partners, L.P. (KMP), an MLP.10 KMP, in turn, distributes all of its available cash to its partners without first paying taxes.11 KMP investors benefit, and KMI also benefits because it received a general partner interest in KMP in exchange for the assets it contributed. Dissecting the Deal This deal includes three steps: 1. KMI buys all outstanding shares of EP. This move will immediately grant KMI control over EPs assets.12 2. KMI sells EPs Exploration & Production (E&P) business. KMI will use the proceeds from the sale to pay down the debt incurred for the cash portion of the buyout of EP. Richard Kinder, chairman and CEO of Kinder Morgan, expects this deal to happen contemporaneously with the closing of the merger transaction. 3. Drop-down of EPs assets to the two MLPs. KMI will sell EPs assets to KMP and El Paso Pipeline Partners, L.P. (EPB), EPs MLP.13 The drop-down will realize two distinct benefits: 1. It will allow KMI to realize the tax benefits of earning money through an MLP avoidance of the corporate tax. 2. To finance the drop-down, the MLPs come to market and raise fresh equity through the sale of units to investors. As the newly acquired assets earn income, distributions will increase, which also increases KMIs general partner interest in KMP and EPB.

Contributions of Property: Section 704(c) The previous section noted that KMP and EPB will soon sell new units to investors. Investors should be wary of what they contribute to the partnership the Code imposes certain rules relating to specific types of property contributed in exchange for a partnership interest.14 The analysis below shows that contribution of 704(c) depreciable property leads to adverse tax consequences for the contributing partner. Therefore, the contributing partner would be welladvised to sell the depreciable property first and contribute the cash proceeds instead. 1. 704(c) Generally The Code generally shields transfers of property in exchange for partnership interests from recognition of gain (or loss).15 But the partnership will recognize gain (or loss) if it later disposes of the property. The partnership will then allocate the gain (or loss) amongst the partners in accordance with the partnership agreement.16 The partnership agreement, however, is not the final word built-in gain and built-in loss properties are treated differently.17 When a partner contributes property to a partnership that has increased or decreased in value, the property has an inherent built-in gain or built-in loss that arose during the period in which the partner owned the property outside of the partnership.18 Thus, at the time of contribution, the property has a tax basis to the partnership that differs from its fair market value (FMV), its book value. Code Sec. 704(c)(1)(A) requires the contributing partner to be taxed on the portion of the gain (or loss) that arose prior to the propertys contribution to the partnership. The partnership may accomplish this by using a method that the IRS will generally find reasonable.19 The analysis is relatively straightforward when the property contributed is non-depreciable (like undeveloped land or stock). But contribution of depreciable property is much more complex and necessarily converts capital gains into ordinary income. Investors should avoid this result.

2. Non-Depreciable Property The analysis begins with a simple example of the contribution of non-depreciable built-in gain property sold for a book gain:20
A and M form an equal partnership in which A contributes raw land with a tax basis of $10,000 and a FMV of $50,000. M contributes $50,000 of cash. The land is Code Sec. 704(c) property because there is a $40,000 appreciation that occurred prior to its contribution to the partnership. Its book value is $50,000 and its tax basis is $10,000. If the partnership were to sell the land for $50,000, the entire gain would be allocated to A. If the land appreciated in the hands of the partnership and it were sold for $100,000, $50,000 of the gain would be split equally between A and M and the built-in gain of $40,000 would be allocated to A. Consistent with the assignment of income principles, M is only allocated a portion of the gain that accrued during the time that he owned the land via the partnership. All of the built-in gain of ($40,000) that accrued prior to contribution is allocated back to the contributing partner.

3. Non-Depreciable Property Book Loss, Tax Gain The basic scheme holds even when the built-in gain property goes down in value in the hands of the partnership. For example:
Taking the facts from the above example, if the land decreased in value to $30,000 and was sold, there would be a tax gain of $20,000 ($30,000 less tax basis of $10,000). Following Code Sec. 704(c) principles, this gain would be allocated to A. M, on the other hand, has suffered an economic loss but has no accompanying tax loss. Remember that M bought an undivided interest in a partnership that owned land worth $50,000. The land had a book value of $50,000 and was sold for $30,000, resulting in a $20,000 book loss. The problem here is that there is no tax loss to match Ms book (or economic) loss. M has run into the so called ceiling rule which prevents a partnership from allocating items of income, gain, loss, and deduction that exceed 100% of the total amounts of such items that the partnership actually recognizes for tax purposes.

The partnership can remedy this problem under the traditional method by waiting until the partnership liquidates to get a tax loss to match his economic loss. M is not allocated a tax loss in conjunction with his book loss because the partnership does not have a tax loss to allocate to him.

4. Depreciable Property Book Loss, Tax Gain The following example shows how the rules effectively convert capital gains (taxed at the preferential rate) into ordinary income for depreciable property that went down in value in the hands of the partnership:21
C and D form an equal partnership to which C contributes equipment with a tax basis of $80 and a value of $120 and D contributes $120 cash. The equipment has four remaining years in its 10-year recovery period and C elected to use the straight line method. C and D agree to share all book items equally.

Thus, C's built-in gain (for tax purposes) is $40. The advantage of a built-in gain is that it is a CAPITAL GAIN waiting to be realized. The partnership steps into the shoes of C with respect to the property. It has a carryover tax basis of $80 and it must depreciate the $80 over the remaining 4 years of useful life. So, tax depreciation to the partnership is $20 per year. Book tax basis is $120, the FMV of the property when contributed.

There is a book rule that the book useful life has to be the same as the tax useful life - 4 years in this case. Since the book value is the FMV of $120, book depreciation is $30 per year. Tax depreciation on the contributed asset to the noncontributing partner D has to be the same as book depreciation - in this case, C and D each take half of $30, or $15. Total tax depreciation is $20 per year (see above). Therefore, because D took $15 of the $20, C gets the remaining $5 of depreciation.

Because C takes in relatively fewer deductions, he will report $10 higher taxable income than D each year, although they have equal book income (book depreciation is $30 - $15 allocated to each). Over the 4 years of remaining life of the asset, C will report $40 higher taxable income than D on the income earned from the partnership. Thus, C has recognized his original $40 gain, albeit as ORDINARY INCOME, spread over four years.

By reporting $40 higher income than D over the 4 years, C has, in effect, realized the built-in gain of $40 - AT ORDINARY INCOME RATES. Having a capital gain converted into ordinary income is the loss of a tax benefit. The income is taxed at 35% rather than at 15%. The longer the partnership holds the asset, the more of the tax advantage C will lose. Conclusion This complex deal offers investors an opportunity to buy units in KMP and EPB, two MLPs with great investment potential. To play the deal right, though, investors should contribute nondepreciable property or cash.

See Michael J. de la Merced and Clifford Kraus, Kinder Morgan to Buy El Paso for $21.1 Billion, N.Y. TIMES, (Oct. 16, 2011), http://dealbook.nytimes.com/2011/10/16/kinder-morgan-to-buy-el-paso/. 2 I.R.C. 7704(d)(1)(E) (2006). 3 See WILLIS & POSTLEWAITE, PARTNERSHIP TAXATION, Seventh Edition (Thomson Reuters/WG&L, 2011, with updates through February 2012) (online version accessed on Checkpoint (www.Checkpoint.riag.com)), 3.04[1]. 4 LAURA E. CUNNINGHAM & NOL B. CUNNINGHAM, THE LOGIC OF SUBCHAPTER K 5 (West ed., 4th ed. 2011). 5 I.R.C. 701 (2006). 6 STEPHEN A. LIND, STEPHEN SCHWARZ, DANIEL J. LATHROPE & JOSHUA D. ROSENBERG, FUNDAMENTALS OF PARTNERSHIP TAXATION 17 (West ed., 8th ed. 2008). 7 See H.R. REP. NO. 100-391, pt. 2, at 1065-66 (1987). 8 I.R.C. 7704(a) (2008). 9 I.R.C. 7704(d)(1)(E) (2008). Congress allowed certain activities that have typically been conducted in partnership form before 7704s enactment to serve as the basis for exemption post-enactment. Supra note 7 at 1066-67. 10 Corporate Profile, KINDER MORGAN, http://www.kindermorgan.com/about_us/about_us_corp_profile.cfm (last visited Mar. 22, 2012). 11 Company History of Kinder Morgan, FUNDING UNIVERSE, http://www.fundinguniverse.com/company-histories/KinderMorgan-Inc-Company-History.html (last visited Mar. 22, 2012). 12 See Kinder, supra note 2. 13 See Jason Stevens, Kinder Morgan Merger with El Paso Will Create Value for Most Stakeholders, SEEKING ALPHA (Dec. 6, 2011) http://seekingalpha.com/article/312019-kinder-morgan-merger-with-el-paso-will-create-value-for-most-stakeholders. 14 See generally I.R.C. 704 (2006). 15 I.R.C. 721 (2006). 16 I.R.C. 704(a) (2006). 17 I.R.C. 704(c)(1)(A) (2006). 18 I.R.C. 704(c) (2006). 19 I.R.C. 1.704-3(b) (2006). 20 Guide to Audit Techniques of Partnerships, IRS, http://www.irs.gov/businesses/partnerships/article/0,,id=134692,00.html (last updated Jan. 25, 2012). 21 CUNNINGHAM & CUNNINGHAM, supra note 5, at 100 (providing the example used).