In the U.S. economy, master limited partnership (MLP) arrangements are gaining significant attention. Energy-related MLPs now represent over $220 billion of aggregate market value as of late 2011, according to Credit Suisse. Three years ago that figure was just $87 billion. Consider these recent developments—all of which point to the importance and growing public profile of MLPs.

MLPs now own significant assets in the midstream oil and gas industry, and a number of midstream oil and gas corporations have yet to transfer permitted assets into more tax-efficient MLP structures and as a result have been mentioned as possible takeover targets.

Kinder Morgan Inc.'s purchase of El Paso Corporation is among the largest energy-related transactions in U.S. history. Kinder Morgan now controls assets of about $65 billion, primarily through its MLP affiliate Kinder Morgan Energy Partners, LP.

Mutual funds and exchange-traded funds focusing on MLPs are now more available to retail and institutional investors. The entrance of institutional investors means MLPs are no longer the domain of mainly private-wealth management investors.

Since 2006, MLPs focused on exploration and production have made a comeback and are growing.

Certain private-equity management firms have organized themselves as MLPs—a fact unlikely to become a trend due to regulatory hurdles—but which nonetheless has drawn attention to MLPs.

mlp asset chart

In 2008, Congress expanded the "qualifying income" definition for the first time since 1987. Now, assets relating to biofuels, biodiesel, ethanol, methanol, liquefied petroleum gas, and even industrial-sourced carbon dioxide may qualify for MLP structuring.

As the public profile and demand for MLPs grows, questions about their taxation are likely to become consequential to the U.S. Treasury and state tax collectors. As such, MLP valuation and taxation will be increasingly scrutinized. This article provides a brief overview of MLP structures and asset-valuation considerations.

Units versus common stock

An MLP, by virtue of being a limited partnership, differs from the more familiar corporate structure, and poses its own set of concerns regarding valuations. While interests in an MLP (commonly known as units) can be freely traded (on public exchanges), those units have characteristics that distinguish them from the common stock of a corporation. The units represent limited partner interests in the enterprise—that is, each unit owns a proportional part of the entity. The general partner, usually the sponsor of the MLP, manages the MLP's operation and is responsible for prompt and accurate reporting to each of the partners, commonly called unitholders.

In a corporation, shareholders receive dividends (if declared), and a Form 1099 reporting those dividends for the year. The effect on a shareholder's current year taxable income usually relates only to the dollars received as a dividend. Undistributed earnings of a corporation, while often important in terms of the price of a corporation's stock, ordinarily have no direct impact on the shareholders. Generally, for corporations, only cash distributions in the form of dividends have a current-year tax effect—so if no dividends are paid, no taxes are payable by the shareholders.

An MLP is different. Partners, or unitholders, receive a schedule K-1 after year-end, showing their share of the partnership's total income and deductions (for the period they owned the units) including depreciation and amortization of intangibles. Information derived from K-1s must be included on the unitholders' tax returns, even if no distributions are made by the MLP. Most MLPs make periodic (usually quarterly) cash distributions.

Depreciation and amortization, as calculated by the MLP, will often provide a 70% to 80% shield, thus reducing the total amount of taxable income allocated by the MLP to the unitholders. The higher the depreciation and amortization, the greater the shield is for the individual unitholders.

MLP valuations

Historically, many MLPs have, in practice, made significant simplifying assumptions in their valuation processes. Consider that, in theory, each time a unitholder sells units, a new valuation of assets is required. This is because the purchaser—the new unitholder—acquires a basis in the MLP's assets based upon the price paid. Therefore, each of the assets of the MLP should be revalued so the basis in the MLP's assets equals the basis in the MLP units acquired. The fair market value (FMV) of the MLP's assets should be reallocated with each change in unit ownership—meaning daily trading should imply daily valuations.

But MLPs cannot accurately and cost effectively value their assets on a daily basis. Thus, the use of simplifying assumptions is common among MLPs. Typically, periodic (such as monthly or quarterly) valuations are used, not daily. And these periodic valuations typically do not include detailed appraisals of plant, property and equipment (PP&E)—a major component of fair market value. Therefore, because PP&E is presumed fixed and working capital is in practice essentially fixed, changes to fair market values must be assigned to the other category relevant to MLPs: intangible assets—and particularly goodwill.

With additional scrutiny sure to continue building, MLPs must consider whether allocating nearly all changes to fair market value to goodwill is reasonable and fair. If changes in goodwill are amortizable under Section 197 of the Internal Revenue Code, then assigning fair market value changes to goodwill may be detrimental to new partners, as the shield associated with goodwill is lower than associated with most PP&E. In virtually every situation, the total FMV of the MLP and the allocation of any changes in value will affect the taxable income allocated to new partners and the character of the gain to the selling partner.

Note, too, that the number of MLPs revaluing tangible assets, as well as intangibles, has been steadily increasing. Recently a number of MLPs that went public five or more years ago have taken steps to update the fair market value of their tangible assets for the purpose of updating FMVs applied in unitholder K-1s.

Valuation methods

With more scrutiny on the MLP sector, managers are taking more care with these simplifying assumptions and allocations of fair market value. How can the management of an MLP be certain that changes in the FMV are 1) properly calculated and 2) correctly apportioned among the various assets?

At one extreme, a new appraisal of the MLP's assets could be undertaken monthly, quarterly, or yearly. Our experience suggests that this approach has rarely been utilized, primarily because of the perceived costs involved. At the other extreme, the present method of valuing the MLP's assets using simplifying assumptions could be employed even if the results may be somewhat arbitrary, as discussed above.

The issue for MLP management is how to obtain, for a reasonable cost, a valuation that accurately reflects the current value of the assets, maximizes the tax benefits for all unitholders, and withstands IRS scrutiny.

One approach to addressing this issue is for MLP management to work with third-party valuation experts to develop limited procedures that can be used to periodically update their asset values. Such periodic updates can be further supported and substantiated by the completion of a full independent appraisal on a regular basis (such as annual or biennial, or other periods).

Regardless of the approach taken, the growing aggregate asset value of the MLP industry all but ensures additional scrutiny by institutional investors and the IRS. In our view, the traditional mechanism of assigning valuation changes to goodwill is coming to an end. n

Robert Schulte is a managing director in the Boston office of Valuation Research Corp. He works with midstream oil and gas companies in support of tax and financial reporting valuation requirements associated with merger, acquisition and IPO transactions.