On Feb. 22, 2012, the Obama administration introduced what it called the “President’s Framework for Business Tax Reform,” which included proposals for reforming the federal income tax on business income.

This document described current rules as “uncompetitive,” “inefficient” and “too complicated” and concluded that these rules distort business-making decisions and fail to sufficiently encourage domestic job creation and investment.

The headline proposal was to reduce the statutory corporate tax rate to 28 percent. At the same the White House and the Department of the Treasury proposed closing a number of loopholes and tax expenditures in order to broaden the tax base.

The Framework also included language that, if codified, would expand the scope of the corporate income tax to potentially include large publicly traded partnerships (PTP) and other pass-through entities.

In short, one of the means the Obama administration proposed to pay for a lower corporate tax rate was to begin taxing the master limited partnerships we cover in MLP Profits at the entity level.

This is clearly an existential threat to MLPs as tax-efficient, high-yield investments. But it is the merest of proposals, as there are precious few details provided in a document that has absolutely no legal significance and hasn’t even found its way into a Congressional bill.

There are two other proposals that have been introduced in Congress, one that comes with bipartisan support and offers tacit support for the idea that MLPs are an effective means of funneling much-needed investment into areas of significant national economic interest.

The President’s Framework set forth principles and high-level explanations for how now proposals for business taxation might be drafted. It left many of the details for further development through the legislative process.

As previously noted, there is as of yet no bill in Congress that would codify the proposal to vitiate the tax advantages large publicly traded partnerships currently enjoy.

If such a proposal were enacted, income that otherwise would be taxed at the top ordinary rate of 39.6 percent in 2013 would instead be subject to a corporate income tax of 28 percent plus a dividend tax of approximately 44 percent on earnings distributed to partners or shareholders.

It’s not clear, however, whether exceptions would be provided for certain pass-through entities that would otherwise be subject to corporate income taxation under the Framework’s proposal. There simply isn’t enough detail yet.

The 2005 report of President George W. Bush’s Advisory Panel on Federal Tax Reform suggested that if large partnerships were subjected to an entity-level tax, exceptions should be provided for regulated investment companies such as mutual funds and REITs.

If exceptions are provided for mutual funds and REITs, it’s not hard to imagine a carve-out for master limited partnerships as well given the effective role they’ve played in directing investment to domestic energy infrastructure.

It’s too soon to make reasonable judgments about how much of an impact the proposal to essentially tax large pass-through entities more like corporations will have on the energy and infrastructure MLPs in our coverage universe.

It is, however, an issue that we’ll be watching closely as the second Obama administration takes shape, negotiations to avoid the Jan. 1, 2013, fiscal cliff progress and the longer-term effort to get the US fiscal house in order unfold.

The President’s Framework also includes a proposal to tax “carried interest” as ordinary income. This proposal has been reduced to more detailed writing, in the form a bill introduced on Feb. 14, 2012, by Rep. Sander Levin (D-MI).

Under existing law many hedge fund managers, private equity partners and other managers in financial partnerships are able to pay a 15 percent capital gains rate on their “labor” income, which is known as “carried interest.”

Financial managers pay a lower tax rate on their income than other workers. The President’s Framework would eliminate the loophole for managers in investment services partnerships and tax carried interest at ordinary income rates.

House Resolution 4016, the Carried Interest Fairness Act of 2012, would amend the Internal Revenue Code to:

• establish a special rule for the inclusion in gross income of partnership interests transferred in connection with the performance of services;
• treat as ordinary income the net capital gain with respect to an investment services partnership interest except to the extent such gain is attributable to a partner’s qualified capital interest;
• exempt income from investment services partnership interests from treatment as qualifying income of a publicly traded partnership;
• increase the penalty for underpayments of tax resulting from failure to treat income from an investment services partnership interest as ordinary income; and
• include income and loss from an investment services partnership interest for purposes of determining net earnings from self-employment and applicable self-employment taxes.

The bill would define “investment services partnership interest” as any interest in a partnership held by a person who provides services to a partnership by advising the partnership about investing in, purchasing, or selling specified assets; managing, acquiring, or disposing of specified assets; or arranging financing with respect to acquiring specified assets.

In short, passage of HR 4016 would change in characterization of carried interest from “capital gains” taxed at the 15 percent advantaged rate to “ordinary income” taxed at individual rates.

On Jun. 7, 2012, Sens. Chris Coons (D–DE) and Jerry Moran (R–KS) introduced Senate Bill 3275, the Master Limited Partnerships Parity Act, which would amend the Internal Revenue Code to expand the definition of “qualifying income” for publicly traded partnerships.

Passage would expand “qualifying income” to include income and gains from renewable and alternative fuels, in addition to fossil fuels, including renewable energy facilities used in the production of electricity, biodiesel, alcohol used as fuels, and renewable fuels used to reduce or replace fossil fuels present in transportation fuels.

The Master Limited Partnerships Parity Act was also introduced to the House of Representatives as HR 6437 by Rep. Ted Poe (R-TX), on Sept. 19, 2012.

Most of the recent legislative focus from the renewable energy community has been on the impending expiration of tax credits related to the investment in and production of electricity through wind.

Sen. Coons has indicated that SB 3275/HR 6437 shouldn’t be seen as a replacement for expiring tax credits but as a complimentary piece of legislation. Without these tax credits or other tax incentives, the benefits of using MLPs alone may not be sufficient to make some renewable energy projects economically viable.

Any tax benefits generated by an MLP structure would be subject to existing limitations on the use of energy tax credits, such as the passive activity loss rules applicable to individuals and the investment tax credit and depreciation limitations related to ownership by tax-exempt entities.

Although the MLP structure will be attractive to a larger range of investors, some of the limitations on the use of tax benefits may mean that the investor audience is still somewhat limited.

Nevertheless, the MLP structure may be a beneficial option for renewable energy project investment, and, if tax credits or other benefits can be used by the MLP investors, renewable energy projects would be even more attractive investments.

Reducing the statutory corporate tax rate is an idea that essentially all interested parties recognize as a good one. However, funding the cost of that rate reduction–via the reduction or elimination of tax loopholes and tax expenditures currently available–will be a matter of contentious debate.

Any effort to impose corporate tax on large pass-through entities will receive a lot of scrutiny. Publicly traded partnerships (PTP), including MLPs, are largely owned by individual investors who won’t appreciate the potential impact on their portfolios.

According to the National Association of Publicly Traded Partnerships approximately 80 percent of PTP equity interests owned by such investors are owned by individuals who are over 50 years old. Cash distributions supplement their retirement income or their plans for retirement.

PTPs generally provide smaller investors with liquid investments in stable assets that provide an attractive cash yield and overall return. PTPs generate mostly ordinary income on which investors pay federal income taxes at ordinary income rates, currently up to 35 percent.

Taxing PTPs at the entity level would significantly reduce the return on their investment, and in doing so would substantially reduce a dependable source of income for these older individuals.

It’s worth noting that these individuals have provided significant new capital to build, acquire and expand the energy infrastructure in the US necessary to transport, store, and process domestic production of natural gas, crude oil, natural gas liquids and refined products.

With the 2012 election now in the past, Washington’s focus will now turn to a debate over the size of government and the need to address deficit reduction without harming the economic recovery.

A “lame duck” session of Congress will likely attempt to extend at least some of the expiring Bush tax cuts as well as some of the corporate preference items, such as the research credit and the renewable energy production tax credit.

Although it’s possible the aforementioned proposals will be part of this debate, it’s not likely that such matters as entity level taxation of publicly traded partnerships and carried interest will be addressed during a compressed session.

The bill to expand the range of MLPs’ qualifying income from fossil fuel-based energy projects such as oil, natural gas, coal extraction and pipeline projects to also include renewable energy projects is one that has bipartisan support, rare in this day and age and an opportunity for an outcome that benefits politicians on both sides of the aisle as well as virtually all Americans.