The Internal Revenue Service has finally addressed the spread of master limited partnerships beyond their traditional energy midstream niche by proposing rules that would limit the involvement of  MLPs in the manufacturing of petrochemicals and paper products.

The draft rules released May 5 attempts to provide clear guidelines for what constitutes a qualifying activity under the statute exempting from corporate income tax the partnerships that derive 90% of their income from qualifying sources.

In addition to passive income such as interest, dividends and rent, such sources can include profits derived from the production, processing, refining, transportation or marketing of minerals or other natural resources subject to depletion.

That broad exemption covers all the traditional energy midstream MLPs, and the rules proposed by the IRS last week won’t change that.

Instead, they aim to limit the expansion of activities qualifying for MLP status based on so-called “private-letter rulings” issued with increasing frequency by the IRS in recent years. Such rulings, sought by MLP sponsors seeking to capitalize on the growing popularity of these investment vehicles, have recently allowed MLPs to engage in non-traditional activities such as fracking sand supply, polyethylene production and oilfield services.

The rules the IRS proposed on May 5 narrow the scope of permissible MLP activities in two main ways.

First, they define processing as the refining or elimination of impurities that does not result in a substantial physical or chemical change to the resource being processed and does not require additional ingredients other than those needed for the production of fuel and lubricants.

In timber processing, that  means wood pellets such as those made by the recently launched Enviva Partners (NYSE: EVA) are confirmed as MLP material while containerboard is barred, dashing the hopes of processors like International Paper (NYSE: IP), which had hoped  to spin off its containerboard operations into an MLP. The proposed rules would also bar MLPs from making pulp by cooking wood chips with additional chemicals in a digester, despite a long-standing private-letter ruling to the contrary.

In petrochemicals, the new rules would exclude the manufacture of ethylene and propylene from MLP qualifying activities except as a byproduct of fuel refining. As described in this week’s MLP Investing Insider, that proposed provision caused a big drop in the unit price of Westlake Chemical Partners (NYSE: WLKP), a recent MLP set up expressly to produce ethylene after its sponsor secured a favorable private-letter ruling from the IRS. Like other partnerships engaged in newly disqualified activities, WLKP would get a 10-year grace period before having to pay corporate income tax.

According to the IRS, the manufacture of ethylene and propylene from ethane and propane with a steam cracker is not a qualifying activity for an MLP because the process alters the inputs’ chemical properties. That proposed rule might have also tripped up Williams Partners (NYSE: WPZ), which bought the Geismar, Louisiana olefins plant from sponsor Williams (NYSE: WMB) in 2012 based on a favorable private-letter ruling. It’s possible that the new rules proposed by the IRS contributed to Wednesday’s announcement that Williams will buy out Williams Partners, although it likely wasn’t the primary consideration.

The IRS proposal also seeks to better define the “certain limited support activities” so “intrinsic” to MLP qualifying income that they too qualify on that basis. Such activities must be “specialized,” essential” and involve “significant services” provided by specially trained employees of the contractor. So well completion services would qualify as intrinsic, for example, while accounting and legal work would not.

The provision of water and sand for hydraulic fracturing appears to qualify as intrinsic only if the provider also handles their disposal, based on one of the examples in the rules proposal. That could affect the MLP status of current Aggressive Portfolio recommendation Hi-Crush Partners  (NYSE: HCLP), which supplies the sand used in fracking but doesn’t handle the disposal of fracking byproducts.

On the other hand, the exclusion of retail sales and deliveries from qualifying marketing and transport activities will not affect portfolio recommendations with significant filling station operations, including Energy Transfer Partners (NYSE: ETP) and Global Partners (NYSE: GLP). Those MLPs already channel their retail sales through income-tax paying corporate subsidiaries. Energy Transfer’s CFO said on last week’s earnings conference call that “based on our review, we believe there is no impact from these regulations for any member of the Energy Transfer family.”

The IRS hasn’t answered all the questions raised by the rapid proliferation of unconventional MLPs. For instance, its proposed rules don’t address the production of fertilizer and the use and transport of carbon dioxide and biofuel, requesting industry comment on those issues.

The public can comment on any aspect of the proposed rules and request a public hearing on them by Aug. 4. The IRS has said it will consider such comments before publishing final rules at a later date. Once the final text is published in the Federal Register, the 10-year grace period for grandfathered partnerships would begin. At the end of that decade, they’d either have to divest non-qualifying activities if those accounted for more than 10% of income, or else start paying the corporate income tax.

Of course, any partnership affected by the proposed regulation and unable to sway the IRS during the comment period would also be free to contest the legality of the new rules in court.

For the traditional midstream MLPs not directly affected by the new rules, they are a modest positive. Any future estimate of the cost of the MLP structure to the federal budget in terms of lost revenue would not include the foregone taxes from petrochemicals or containerboard, and MLP critics would have less cause to claim the partnerships are eroding the corporate tax base.

On the other hand, some energy MLPs like Enterprise Products Partners (NYSE: EPD) and Sunoco Logistics (NYSE: SXL) have been ramping up their own involvement in petrochemicals. They’ll have to decide whether the limits proposed by the IRS are worth contesting.