Mastering Reporting of Publicly Traded Partnership and MLP K-1s on Partners' Returns Navigating MLP K-1 Footnotes and Tying Information to the 1040

Mastering Reporting of Publicly Traded Partnership and MLP K-1s on Partners' Returns Navigating MLP K-1 Footnotes and Tying Information to the 1040 WEDNESDAY, JANUARY 18, 2017, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be emailed to registered attendees. To earn full credit, you must remain connected for the entire program. FOR LIVE PROGRAM ONLY WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

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Mastering Reporting of Publicly Traded Partnership and MLP K-1s on Partners' Returns Jan. 18, 2017 James E. Marker, II, CPA, Tax Manager Sisterson & Co., Pittsburgh jemarker@sisterson.com Joseph P. Nicola, Jr., Tax Partner Sisterson & Co., Pittsburgh jpnicola@sisterson.com

Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

Mastering Reporting of Publicly-Traded Partnership and MLP K-1s on Partners' Returns January 18, 2017 Joseph P. Nicola, Jr., CPA, JD, CVA James E. Marker, CPA Sisterson & Co., LLP Pittsburgh, PA jpnicola@sisterson.com jemarker@sisterson.com 5

General Section 7704 Section 7704(a) provides that a publicly traded partnership is treated as a corporation for tax purposes. See PLR 201651008 (July 19, 2016). 6

General Section 7704 Section 7704(b) provides that the term publicly traded partnership (PTP) means any partnership if interests in that partnership are traded on: An established securities market, or A secondary market. 7

General Section 7704 Section 7704(c)(1) provides that a publicly traded partnership will not be treated as a corporation for tax purposes if the partnership meets the gross income requirements of Section 7704(c)(2) for all taxable years of its existence. 8

General Section 7704 Section 7704(c)(2) explains that a partnership meets the gross income requirements for any taxable year if 90 percent or more of the gross income for the taxable year is qualifying income. 9

General Section 7704 Section 7704(d)(1)(E) defines qualifying income to include income and gains derived from the exploration, development, mining or production, processing, refining, transportation, or marketing of minerals or natural resources. 10

General Section 7704 Income from marketing minerals or natural resources to end users at the retail level is not qualifying income. For example, income from retail marketing with respect to refined petroleum products (e.g., gas station operations) is not treated as qualifying income. S. Rep. No. 445, 100 th Cong., 2d Sess. 424 (1988). 11

Proposed Regulation Section 1.7704-4 In May 2015, the IRS issued Proposed Regulation Section 1.7704-4. The proposed regulation describes "qualifying activities" to include: 12

Proposed Regulation Section 1.7704-4 The exploration, development, mining or production, processing, refining, transportation, or marketing of minerals or natural resources (referred to as 7704(d)(1)(E) activities"), and... 13

Proposed Regulation Section 1.7704-4 Certain support activities that are intrinsic to 7704(d)(1)(E) activities ( intrinsic activities ). 14

Proposed Regulation Section 1.7704-4 Exploration Under the proposed regulation, "exploration" is an activity performed to ascertain the existence, location, extent, or quality of a resource deposit before the development stage of the resource begins. 15

Proposed Regulation Section 1.7704-4 Development/Mining/Production Development is any activity performed to make minerals or natural resources accessible. Mining or production is an activity performed to extract minerals or other natural resources from the ground. 16

Proposed Regulation Section 1.7704-4 Transportation/Marketing "Transportation" is defined as the movement of the natural resources and includes storing the resources. "Marketing" includes activities undertaken to facilitate the sale of the natural resources or the products or processing or mining of the resources. 17

Proposed Regulation Section 1.7704-4 Transportation/Marketing The foregoing activities include fluid management, transportation, disposal, washout, and storage services, as well as hydrocarbon remediation services performed as part of the disposal process. PLR 201637007 (June 13, 2016) and PLR 201633020) (August 15, 2016). 18

Proposed Regulation Section 1.7704-4 Transportation/Marketing Also included are inter-well water transfer services, processing, treatment and disposal of waste solids and waste fluids, including washout services, and... 19

Proposed Regulation Section 1.7704-4 Transportation/Marketing Recovery, recycling, and marketing of brine, chemicals, and drilling mud to oil and gas producers and of hydrocarbons other than to end users at the retail level. PLR 201602004 (September 25, 2015). 20

Proposed Regulation Section 1.7704-4 Intrinsic Activities Activities are considered intrinsic activities for these purposes only if they are: Specialized to support 7704(d)(1)(E) activities, Essential to the completion of 7704(d)(1)(E) activities, and Require the provision of significant services to support 7704(d)(1)(E) activities. 21

Proposed Regulation Section 1.7704-4 Intrinsic Activities - Specialized An activity is "specialized" if both the personnel performing the activity and any property used in the activity are specialized. 22

Proposed Regulation Section 1.7704-4 Intrinsic Activities - Specialized Property is considered specialized if it is used only in connection with 7704(d)(1)(E) activities and cannot be used (or converted to be used) outside of those activities. 23

Proposed Regulation Section 1.7704-4 Intrinsic Activities - Specialized Injectants such as water, lubricants, and sand are also considered specialized property regardless of whether they can be used outside of 7704(d)(1)(E) activities. 24

Proposed Regulation Section 1.7704-4 Intrinsic Activities Significant Services The partnership may meet the "significant services" requirement by providing services with respect to the activity either at the location of the activity or off-site. 25

The Master Limited Partnership A master limited partnership (MLP) generally refers to a PTP that operates an active business, typically in the oil & gas or pipeline industry. 26

The Master Limited Partnership Most MLPs are structured in such a way as to satisfy the qualifying income test, thereby resulting in partnership treatment for tax purposes. Throughout the balance of this presentation, we will refer to the MLP as either an MLP or a partnership. 27

The Master Limited Partnership MLPs are usually structured as tiered limited partnerships. The parent is typically a limited partnership. 28

The Master Limited Partnership The business operations are often carried out by subsidiary entities owned by the parent. The parent is publicly traded, and referred to as the MLP. 29

The Master Limited Partnership Investors are usually limited partners. Investment is usually denominated in units or shares (usually units). 30

The Master Limited Partnership The MLP has an advantage over other partnerships in that it has better access to capital markets that are typically reserved to the corporation form of doing business. 31

The Master Limited Partnership Taxation Advantages of Partnership Treatment From a tax perspective, an MLP taxed as a partnership has an advantage over entities taxed as C corporations. The term C corporation is a reference to Subchapter C, which is part of Subtitle A, Chapter 1 of the Code. 32

The Master Limited Partnership Taxation Advantages of Partnership Treatment C corporations and their shareholders are said to be subject to the double-tax regime of the Internal Revenue Code. C corporations are subject to tax at the entity level. Section 11. 33

The Master Limited Partnership Taxation Advantages of Partnership Treatment Then, under Section 301(c), distributions from corporate earnings and profits are taxed as dividends at the shareholder level. See also Section 316. 34

The Master Limited Partnership Taxation Advantages of Partnership Treatment Conversely, under Subchapter K, partnerships are not taxed, so that the single tax regime is said to apply. 35

The Master Limited Partnership Taxation Advantages of Partnership Treatment The partners (unit holders in the case of an MLP) are taxed on the income of the partnership. Section 702(a). This is referred to as flow-though or pass-through taxation. 36

The Master Limited Partnership Taxation Advantages of Partnership Treatment Sections 705 and 731 act in tandem to protect partners, such as unit holders, from double taxation. Section 705 provides for adjustments to the basis of a unit holder s units. 37

The Master Limited Partnership Taxation Advantages of Partnership Treatment Items of income increase the basis of the units. Losses, deductions and distributions reduce basis. 38

The Master Limited Partnership Taxation Advantages of Partnership Treatment Section 731 provides that cash distributions to the unit holder are not taxable until they exceed the unit holder s basis in his or her units. Section 731(a). 39

The Master Limited Partnership Taxation Advantages of Partnership Treatment Distribution Example Suppose X purchases 100 units of MLP in 2016 for $100,000, and, for 2016, the MLP reports to X (on Schedule K-1) $20,000 of ordinary income. If the MLP distributes $15,000 to X, that distribution will not be taxable to X. X s basis after the distribution will be $105,000, as follows. 40

The Master Limited Partnership Taxation Advantages of Partnership Treatment Distribution Example Cost of units 100,000 2016 income 20,000 Basis after adjustment for income 120,000 Basis after adjustment for income 120,000 Distribution (15,000) Basis after distribution 105,000 The distribution is a tax-free return of capital. 41

The Master Limited Partnership Taxation Disadvantages of Partnership Treatment There are also disadvantages to partnership treatment. 42

The Master Limited Partnership Taxation Disadvantages of Partnership Treatment First, the MLP must prepare and issue Schedule K-1 to each of its investors. Schedule K-1 reflects each unit holder s share of MLP income, gains, losses, deductions, and credits, as well as distributions. 43

The Master Limited Partnership Taxation Disadvantages of Partnership Treatment The Code allows for flexibility in allocating these items among the unit holders that may not be proportionate to their ownership interests. This is the good news. The bad news is that, as a result, allocations (sometimes called special allocations ) can be a computational nightmare. 44

The Master Limited Partnership Taxation Disadvantages of Partnership Treatment This can be a costly exercise, and is one that is not incurred by an entity that is taxed as a C corporation. 45

The Master Limited Partnership Taxation Disadvantages of Partnership Treatment Second, the sale of units is significantly more complex in comparison with the sale of corporate stock. The sale of corporate stock generally gives rise to capital gain or loss under Section 1221, and the inquiry ends there. 46

The Master Limited Partnership Taxation Disadvantages of Partnership Treatment The sale of units in the case of an MLP is treated as a sale a partnership interest. 47

The Master Limited Partnership Taxation Disadvantages of Partnership Treatment Depending on the facts, part of the sale may give rise to ordinary income under the so-called hot asset rule of Section 751, while part of the gain may give rise to capital gain or loss under Section 741. 48

Important considerations: Schedule K-1 Overview Cover letter. Schedule K-1. Pass-through items and distributions. Supplemental information. Units owned and schedule of units purchased and sold. 49

Schedule K-1 Overview 50

Schedule K-1 Overview 51

Schedule K-1 Overview 52

Schedule K-1 Overview 53

Reporting Schedule K-1 Information on a Unit Holder s Form 1040 Several important starting points. The cover letter accompanying Schedule K-1 often contains material information. 54

Reporting Schedule K-1 Information on a Unit Holder s Form 1040 55

Reporting Schedule K-1 Information on a Unit Holder s Form 1040 56

Reporting Schedule K-1 Information on a Unit Holder s Form 1040 Unlike more basic pass-through investments, the reportable information is not only found on Page 1, Part III of Schedule K-1, but must also be extracted from the supplemental information statements and/or footnotes. 57

Reporting Schedule K-1 Information on a PTPs are identified in Part I Box D Unit Holder s Form 1040 58

Reporting Schedule K-1 Information on a Unit Holder s Form 1040 59

Reporting Schedule K-1 Information on a Unit Holder s Form 1040 60

Passive Activity Loss Rules and MLPs An MLP will generally be a passive activity for most investors. The passive activity loss rules for MLPs differ from passive activity loss rules for partnerships that are not MLPs. 61

Passive Activity Loss Rules and MLPs The general rule under Section 469 provides that passive activity losses may only offset passive activity income, unless the activity is disposed of in a taxable transaction. The general rule permits losses from one passive activity to offset passive activity income of another entity. 62

Passive Activity Loss Rules and MLPs In the case of an PTP, however, Section 469(k) provides that the passive activity limitations apply on an PTP-by- PTP basis. Thus, unit holders are required to treat each MLP separately for purposes of calculating passive activity losses. Section 469(k). 63

Passive Activity Loss Rules and MLPs The passive activity income from one MLP cannot be used to allow passive activity losses from another MLP or another passive activity. And... 64

Passive Activity Loss Rules and MLPs Passive activity losses from one MLP cannot be allowed to offset passive activity income from other MLPs or other passive or nonpassive activities. One exception to this rule: If the entire interest in the MLP is disposed in a fully taxable transaction, losses are deductible and thus may offset other passive and nonpassive income. 66

Passive Activity Loss Rules and MLPs Note that, unlike non-ptp partnerships, mere disposition of the activities (or subsidiary entities) of an MLP will not constitute a disposition for this purpose. Section 469(k)(3). The unit holder must dispose of all units. 67

Passive Activity Loss Rules and MLPs In summary, suspended passive activity losses must be carried forward until either: The MLP has passive income that can be applied to offset its suspended loss, or The unit holder disposes of the entire MLP interest in a fully taxable transaction. 68

Passive Activity Loss Rules and MLPs Reporting Example As an example, suppose a unit holder has a suspended passive activity loss carryover from MLP A of $10,000. 69

Passive Activity Loss Rules and MLPs Reporting Example For the current year (year 1), suppose that her share of MLP A passive activity income is $5,000. Now, suppose that the unit holder also owns MLP B, and her share of current-year (year 1) income from that MLP is $10,000. 70

Passive Activity Loss Rules and MLPs Reporting Example Her net loss from MLP A is $5,000. This loss cannot be deducted against income from MLP B and is suspended. 71

Passive Activity Loss Rules and MLPs Reporting Example MLP A MLP B Suspended loss (10,000) - Year 1 5,000 10,000 Year 1 net income (loss) (5,000) 10,000 Part of M LP A suspended loss used. 72

Passive Activity Loss Rules and MLPs Reporting Example Suppose that, in year 2, MLP B reports a loss of $10,000 to the unit holder on her Schedule K-1 and MLP A reports Schedule K-1 income of $10,000 to her. Taxable income from MLP A is $5,000. The entire $10,000 loss from MLP B is suspended. 73

Passive Activity Loss Rules and MLPs Reporting Example MLP A MLP B Suspended loss (10,000) - Year 1 5,000 10,000 Year 1 net income (loss) (5,000) 10,000 Part of M LP A suspended loss used. Suspended loss (5,000) - Year 2 10,000 (10,000) M LP B loss cannot be used. Year 2 net income (loss) 5,000 - M LP A suspended loss used. 74

Passive Activity Loss Rules and MLPs Reporting Example Finally, in year 3, the unit holder disposes of her entire interest in MLP B in a fully taxable transaction. She has no other income or loss from MLP A or MLP B. The net loss from MLP B of $10,000 is fully deductible. 75

Passive Activity Loss Rules and MLPs Reporting Example MLP A MLP B Suspended loss (10,000) - Year 1 5,000 10,000 Year 1 net income (loss) (5,000) 10,000 Part of M LP A suspended loss used. Suspended loss (5,000) - Year 2 10,000 (10,000) M LP B loss cannot be used. Year 2 net income (loss) 5,000 - M LP A suspended loss used. Suspended loss - (10,000) Year 3 - - Year 3 net income (loss) - (10,000) M LP loss deductible (sold). 76

Passive Activity Loss Rules and MLPs How to Report on Form 1040 MLP passive income, gains and losses are not reported on Form 8582. Each unit holder must calculate his or her share of income and losses. 77

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Unit holders will be required to prepare workpapers that will combine any current year income, gains, and losses, with prior-year suspended losses on a PTP-by- PTP basis. For this purpose, the IRS recommends using Worksheets 5, 6, and 7 of Form 8582. 78

Passive Activity Loss Rules and MLPs How to Report on Form 1040 In completing this calculation, the unit holder will include only the same types of income and losses that are included in figuring net income or loss from a non- MLP passive activity. 79

Passive Activity Loss Rules and MLPs How to Report on Form 1040 If the result is an overall net gain or income, the result is nonpassive income. 80

Passive Activity Loss Rules and MLPs How to Report on Form 1040 The unit holder will report all component items of income, gains and allowed losses from the MLP on the appropriate forms or schedules normally included with Form 1040, and, to the left of each entry space, enter From PTP. 81

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example As an example, suppose a unit holder has Schedule E income of $8,000 and a prior-year suspended Form 4797 Section 1231 loss of $3,500 from the passive activities of an MLP. The result is a $4,500 overall gain ($8,000 - $3,500) that is nonpassive income. 82

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example On Schedule E, Part II, Line 28, the unit holder will report the $4,500 net gain as nonpassive income in column (j). Column (a) will reflect the name of the MLP and the words From PTP. 83

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example In column (g), the unit holder will report the remaining Schedule E gain of $3,500 ($8,000 - $4,500) as passive income. 84

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example 85

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example On the appropriate line of Form 4797, the unit holder will report the prior-year unallowed loss of $3,500, and enter "From PTP" to the left of the entry space. 86

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Example 87

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Another Example As another example, suppose a unit holder has a Schedule E loss of $24,000 and Form 4797 Section 1231 gain of $14,000 from the passive activities of an MLP. The result is a $10,000 overall loss that is suspended and thus carried forward. 88

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Another Example On Schedule E, Part II, Line 28, the unit holder will report the $14,000 loss as a passive activity loss in column (f). 89

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Another Example 90

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Another Example On the appropriate line of Form 4797, the unit holder will report the gain of $14,000, and enter "From PTP" to the left of the entry space. 91

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Another Example 92

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities Unlike more basic pass-through activities, MLPs often hold multiple subsidiary entities as assets. The application of the passive activity loss rules to tiered MLPs is unclear. Can the loss of one subsidiary offset the income of another? 93

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities In the case of a tiered MLP, it is critical for tax advisers of unit holders to complete the passive activity calculations on a per-activity or per-subsidiary basis. 94

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities This is so, regardless of the position that the advisor takes regarding the netting of the passive activity income and losses among the activities or subsidiaries. 95

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities The practice of completing calculations in the workpapers on a subsidiary-by-subsidiary basis is advisable in the event the IRS takes the position that the passive activity losses of one subsidiary or activity cannot be offset against the passive activity income of another subsidiary/activity. 96

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities MLPs holding multiple subsidiaries in their portfolio will provide supplemental information for passive activity purposes. 97

Passive Activity Loss Rules and MLPs How to Report on Form 1040 Tiered Entities and Multiple Activities 98

Passive Activity Loss Rules and MLPs Tiered Entities and Multiple Activities 99

Passive Activity Loss Rules and MLPs Tiered Entities and Multiple Activities 100

Passive Activity Loss Rules and MLPs Tiered Entities and Multiple Activities 101

Sales of MLP Interests Sales of MLP units are reported on Form 1099-B (reported as the disposition of a traded security). However, due to the treatment of MLPs as partnerships for tax purposes, some component of the sale proceeds will be treated as ordinary income for tax purposes. 102

Sales of MLP Interests Schedule K-1 will include a sales worksheet which generally will disclose the portion of the proceeds that must be reported as ordinary income. 103

Basis of Units Sold The sales worksheet generally contains the following information: Number of units sold. Acquisition and disposition dates. Adjustments to basis. Ordinary gain component of proceeds. AMT adjustments (reported on Form 6251). 104

Sales of MLP Interests Sales Worksheet Disclosure 105

Sales Worksheet 106

Sales of MLP Interests Form 1099-B Tax advisers and preparers will need to reconcile the data on Form 1099-B with the sales worksheet in order to segregate ordinary income from capital gains. 107

Sales of MLP Interests Basis Calculations Unit holders are required to calculate basis using the average basis method (sometimes called the unitary basis method). The unit holder s cost basis for the entire investment is divided by the total number of units to arrive at a basis per unit. Rev. Rul. 84-53, 1984-1 C.B. 159. 108

Sales of MLP Interests Basis Calculations Specific identification and FIFO are not permitted. Cf. PLR 200909001 (S corporation permitted to specifically identify, though this may have been appropriate to address the impact of the built-in gains tax). The averaging approach runs counter to that which public investors are accustomed. 109

Sales of MLP Interests Basis Calculations Suppose A acquired 600 units in an MLP on January 1 for $20 per unit. On June 1, A acquired 700 units in the MLP for $25 per unit. On December 1, A sold 500 units for $30 per unit. Assuming no adjustments to A s basis during the year, A s results are as follows: 110

Sales of MLP Interests Reporting Example Amount realized Units sold 500 Selling price per unit 30 15,000 Basis January 1 June 1 Total Units 600 700 1,300 Cost per unit 20 25 Cost 12,000 17,500 29,500 Cost per unit 22.69 Units sold 500 11,346 Gain 3,654 111

Sales of MLP Interests Basis Calculations A unit holder is permitted to use the actual holding period of the units sold. Reg. 1.1223-3(c)(2). 112

Special Considerations for Oil & Gas MLPs Most oil & gas investment vehicles are organized as MLPs due to tax advantages available to oil & gas partnerships. 113

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs and Depletion Two tax benefits specific to oil & gas/energy investments are intangible drilling costs (IDCs) and depletion. Each of these presents calculation and reporting challenges. 114

IDCs are costs that: Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Are necessary and incidental to the drilling of wells, and Have no salvage value. Regulation Section 1.612-4(a). 115

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs IDCs are currently deductible under Section 263(c), and are reported to the unit holders on Schedule K-1 Line 13 Code J. Note, however, that an MLP that holds a working interest (as opposed to a mere royalty interest) may elect to capitalize IDCs (usually as leasehold costs). 116

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs In general, such capitalized costs are then deducted over a period of time via depletion. This occurs infrequently. 117

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs More frequently, the MLP will treat the IDCs as currently deductible by passing them through on Schedule K-1 Line 13 Code J to each unit holder. The unit holder may, if advantageous, make an annual election to capitalize all or a portion of the IDCs and deduct those costs ratably over a five-year period under Section 59(e)(4). 118

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs As discussed below, capitalization at the unit holder level should be considered when the unit holder is in an alternative minimum tax (AMT) or a net operating loss position. 119

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs If the unit holder elects to capitalize IDCs, the unit holder s share of basis in the property of the MLP according to the MLP s records will differ from the unit holder s share of basis according to the unit holder s records. 120

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs This is significant since the MLP may report inaccurate data to the unit holder when the MLP sells the property. 121

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Under those circumstances, any unit holder who has chosen to capitalize IDCs will need to exercise caution in computing his or her allocable share of gain or loss. 122

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example Suppose X MLP is composed of three equal unit holders, A, B and C. During 2015, X incurred IDCs of $600,000 on January 1. $200,000 is passed through to each unit holder on Schedule K-1 Line 13 Code J. 123

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example A and B deduct their shares of IDC, while C elects to capitalize and amortize $150,000 of her $200,000 of IDC. 124

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example Based on the foregoing, C will deduct $80,000 of IDCs on her 2015 Form 1040, comprised of $50,000 that she did not elect to capitalize, as well as one-fifth, or $30,000, of the remaining $150,000 that she elected to capitalize and amortize. 125

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example IDCs 200,000 Less capitalized portion (150,000) 50,000 Amortization Capitalized IDCs 150,000 Years 5 30,000 80,000 126

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example C s Share of Property Basis Cost (IDCs) 200,000 Less amount deducted (80,000) 120,000 127

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example Assume that X sells the property in 2016 for $1.2 million. For 2016, X will provide data to the unit holders on Schedule K-1 Line 11 Code F ( Other Income ) that may be based on an assumption that the unit holder did not capitalize any IDCs. 128

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example As such, C s records will indicate that her share of the basis of the disposed property is $120,000 higher than that which is reflected in X s records. 129

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example Property Basis MLP Records A B C Unit holder share of property basis at 1/1/2016 200,000 200,000 200,000 2016 IDC (200,000) (200,000) (200,000) Unit holder share of property basis at 12/31/2016 - - - Sale A B C Selling Price $1.2 million 400,000 400,000 400,000 Basis - - - Gain according to the MLP's records 400,000 400,000 400,000 131

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example Property Basis Unit Holder Records A B C Unit holder share of property basis at 1/1/2016 200,000 200,000 200,000 2016 IDC (200,000) (200,000) (80,000) Unit holder share of property basis at 12/31/2016 - - 120,000 Sale A B C Selling Price $1.2 million 400,000 400,000 400,000 Basis - - (120,000) Gain to be reported on Form 1040 400,000 400,000 280,000 132

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs Example MLPs should notify their unit holders that they must recalculate their gains and losses if they made an election to capitalize under Section 59(e)(4). Some practitioners have used Form 8082 to report any resulting differences. 133

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT As stated above, if the MLP does not capitalize and amortize its IDCs, they can be deducted by the unit holder in the year the expenditures are paid or incurred. 134

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT If they are currently deducted, an AMT preference can result. The Section 59(e) capitalization election addressed above serves another purpose. It allows a unit holder to eliminate the AMT preference. 135

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT The Section 59(e) election is made by completing the Amortization section of Form 4562 (Depreciation and Amortization). The Code does not require a specific election statement. 136

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT The regulations, however, indicate that the election should be made on a statement attached to the unit holder's income tax return (or amended return) for the tax year in which the IDC amortization begins. Reg. Section 1.59-1(b)(1). 137

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT If the Section 59(e) election is not made, then the AMT preference must be computed. 138

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT The starting point is Section 57(a)(2), which provides that a tax preference item exists to the extent that a taxpayer's excess intangible drilling costs exceed 65 percent of the net income from the property. 139

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT Excess intangible drilling costs are defined as the amount by which IDCs exceed the amount which would have been deducted had the costs been capitalized and amortized on a straight-line basis over a 120-month period. 140

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT Each unit holder s share of this amount is reported on Schedule K-1 Line 17 Code F. 141

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT The next step is to compute the actual amount that will be included in the unit holder s AMT calculation on Form 6251. In general, even in the absence of a Section 59(e) election, most individual taxpayers should be able to avoid any adverse AMT impact. 142

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT This is due to the fact that Congress enacted a limited exemption for independent producers, including individual investors in partnerships that are independent producers. Section 57(a)(2)(E). 143

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs - AMT Independent producers are generally defined to include drillers and exploration/production ( upstream ) companies. 144

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT The exemption is limited, however, by a computational rule in Section 57(a)(2)(E). The exemption cannot result in a reduction to the unit holder s alternative minimum taxable income (AMTI) by more than 40% of AMTI computed as though the exemption did not exist. 145

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Thus, two computations are required. In the first, AMTI is computed as though the full amount of the excess IDCs were required to be included as a tax preference item. 146

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Second, the resulting AMTI is multiplied by 40%. The result represents the maximum amount by which the AMTI can be reduced. 147

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Example Suppose a unit holder s Schedule K-1 reflects $250,000 of IDCs on a well that started producing July 1, 2016. Gross income from the property was $60,000. 148

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Example Lease operating expenses for the property were $20,000. Finally, suppose AMTI before this tax preference is $250,000. The amount of the tax preference would be $219,624, computed as follows: 149

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Example Actual IDCs 250,000 Amortization (6 months/120 months) (12,500) Excess IDCs 237,500 Gross income from property 60,000 Lease operating expenses (20,000) Amortization from above (12,500) 27,500 65% of net income from the property 65% 17,875 Tentative tax preference item 219,625 150

Special Considerations for Oil & Gas MLPs Intangible Drilling Costs AMT Example AMTI before tax preference 250,000 Tentative IDC preference 219,625 AMTI after tax preference 469,625 Maximum reduction percentage 40% Maximum reduction of IDC preference 187,850 Tentative IDC preference 219,625 Maximum reduction of IDC preference (187,850) Tax preference IDC after the reduction 31,775 AMTI before tax preference 250,000 Form 6251 Tax preference IDC after the reduction 31,775 Line 26 AMTI 281,775 151

Special Considerations for Oil & Gas MLPs Depletion The IRS defines depletion as the using up of natural resources by mining, drilling, quarrying stone, or cutting timber. According to the IRS, the depletion deduction allows an owner or operator to account for the reduction of a product's reserves. See Publication 225, Farmer s Tax Guide, Chapter 7, Depreciation, Depletion, and Amortization, p. 46 (IRS 2015). 152

Special Considerations for Oil & Gas MLPs Depletion Oil & gas partnerships report depletion annually on each unit holder s Schedule K-1 in proportion with the unit holder s economic interest. 153

Special Considerations for Oil & Gas MLPs Depletion The actual amount of the deduction is determined at the unit holder level pursuant to Section 613A(c)(7)(D). In other words, no depletion deduction is claimed at the MLP level. Section 703(a)(2)(F). 154

Special Considerations for Oil & Gas MLPs Depletion Taxpayers may elect to utilize either percentage depletion or cost depletion and deduct the greater of the two calculated numbers. Reg. Section 1.611-1(a). This comparison is completed on a property-byproperty basis. Id. 155

Special Considerations for Oil & Gas MLPs Depletion Percentage depletion is calculated based on a percentage, currently 15%, of gross income from the property, but is limited by statute to "taxable income from the property. Section 613(b)(2). 156

Special Considerations for Oil & Gas MLPs Depletion Cost depletion is computed by the MLP (more likely by its operating subsidiaries). The computation begins by dividing the leasehold costs of the mineral interest by the estimated recoverable reserves (which results in the cost per unit ). The result is then multiplied by the number of units sold during the tax year. Reg. Section 1.611-2(a). 157

Special Considerations for Oil & Gas MLPs Depletion Since the depletion deduction is determined at the unit holder level, the MLP must allocate to each unit holder his or her share of every item that is part of the deduction calculation. Reg. Section 1.613A-3(e). 158

Special Considerations for Oil & Gas MLPs Depletion Thus, Schedule K-1 will include a schedule that will reflect each unit holder s share of cost depletion and percentage depletion on a property-by-property basis. 159

Special Considerations for Oil & Gas MLPs Depletion Moreover, each unit holder s Schedule K-1 will reflect his or her share of gross income and net income from each property, as well as the components of net income from each property. 160

Special Considerations for Oil & Gas MLPs Depletion Example of an Attachment to Schedule K-1 Representing the Unit Holder s Share of Each Item WELL OIL SALES GAS SALES TOTAL REVENUE OPER EXP DEPR O/H NET INCOME TENTATIVE STATUTORY DEPLETION (15%) COST DEPL GREATER OF COST OR PERCENTAGE DEPL Well A 300,000 100,000 400,000 (64,000) (17,000) (6,000) 313,000 60,000 62,000 62,000 Well B 200,000 500,000 700,000 (132,000) (85,000) (16,000) 467,000 105,000 88,000 105,000 167,000 161

Special Considerations for Oil & Gas MLPs Depletion Note the reference to tentative statutory depletion. This is sometimes referred to as tentative depletion or assumed allowable depletion, which represents the percentage depletion calculated by partnership prior to any comparison to cost depletion. 162

Special Considerations for Oil & Gas MLPs Depletion Capital Accounts While depletion is calculated at the unit holder level, it must nonetheless be reflected in each unit holder s capital account. Regulation Section 1.704-1(b)(2)(iv)(k) provides two methods: Simulated depletion Actual depletion. 163

Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Regulation Section 1.704-1(b)(2)(iv)(k)(2) provides the rules related to simulated depletion. 164

Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Simulated depletion is computed on a property-byproperty basis using either cost or percentage depletion at the MLP level (as demonstrated above), but without consideration of any limitations applicable at the unit holder level, such as the 65%-of-taxableincome limitation discussed below. 165

Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Three components should be disclosed in the footnotes and schedules accompanying Schedule K-1: Cost depletion. Percentage depletion (up to property basis) in excess of cost depletion. 166

Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Percentage depletion in excess of the basis of property allocated to the unit holder. 167

Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Example of the Components WELL TENTATIVE STATUTORY DEPLETION (15%) COST DEPL GREATER OF COST OR PERCENTAGE DEPL PROPERTY BASIS COST DEPL PERCENTAGE DEPLETION UP TO BASIS PERCENTAGE DEPLETION IN EXCESS OF BASIS Well A 60,000 62,000 62,000 62,000 62,000 - - Well B 105,000 88,000 105,000 88,000-88,000 17,000 167,000 62,000 88,000 17,000 168

Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Note that the book capital account of the unit holder may not be equal to the unit holder s tax basis in the MLP interest as a result of this process. 169

Special Considerations for Oil & Gas MLPs Depletion Capital Accounts The capital account is reduced by the entire amount of simulated depletion, while tax basis is reduced by depletion to the extent of the unit holder s share of the MLP s basis in the property. Section 705(a)(3). This is part of the reason for the disclosure of the three components of depletion set forth above. 170

Special Considerations for Oil & Gas MLPs Depletion Capital Accounts Alternatively, Regulation Section 1.704-1(b)(2)(iv)(k)(3) permits the unit holder s book capital account to be reduced by the unit holder s actual depletion deduction. This method is seldom used, since the MLP seldom has access to individual unit holder records. 171

Special Considerations for Oil & Gas MLPs Unit Holder s Depletion Deduction The percentage depletion deduction cannot exceed 65% of the unit holder s taxable income for the year, computed without regard to the depletion allowance or any net operating loss carryovers or carry backs. Section 613A(d)(1). Any disallowed depletion is carried forward to future years. 172

Special Considerations for Oil & Gas MLPs Unit Holder s Depletion Deduction Assume a unit holder has 2016 taxable income of $300,000, excluding a depletion deduction as a result of an investment in XYZ Partnership. XYZ owns three properties. Assume further that the unit holder receives Schedule K-1 with the following items related to depletion. 173

Special Considerations for Oil & Gas MLPs Unit Holder s Depletion Deduction X Y Z Percentage depletion 180,000 270,000 150,000 Cost depletion 120,000-30,000 Total tentative depletion 600,000 Taxable income limitation Taxable income 300,000 65% of net income from the property 65% Limitation 195,000 174

Special Considerations for Oil & Gas MLPs Unit Holder s Depletion Deduction Allocation of Limitation X Y Z Total Percentage depletion 180,000 270,000 150,000 600,000 Percentage depletion as limited* 58,500 87,750 48,750 195,000 Cost depletion** 120,000-30,000 Percentage depletion as re-limited*** - 125,357 69,643 195,000 Depletion deduction greater of cost or percentage depletion 120,000 125,357 69,643 315,000 * Allocated in proportion to tentative percentage depletion. ** Cost depletion is compared to percentage depletion, as limited. *** Since cost depletion exceeds percentage depletion on Property X, the taxable income limitation is re-allocated between Properties Y and Z. 175

Special Considerations for Oil & Gas MLPs Depletion Impact on Basis in MLP Interest As suggested above, depletion is not deducted at the MLP level. As such, depletion as computed by the MLP cannot reduce the basis of a unit holder s interest under the general basis rules. 176

Special Considerations for Oil & Gas MLPs Depletion Impact on Basis in MLP Interest Rather, as stated above, Section 705(a)(3) requires the reduction of the basis of each unit holder s interest by the amount of his or her oil and gas depletion deduction to the extent the deduction does not exceed the unit holder s share of the MLP's basis in the property. 177

Special Considerations for Oil & Gas MLPs MLP Sale of Depletable Property When the partnership sells the underlying property, then the capital accounts of the unit holders must be adjusted by the simulated gain or loss, assuming that the capital accounts were previously adjusted by simulated depletion. 178

Special Considerations for Oil & Gas MLPs MLP Sale of Depletable Property In completing this computation, the MLP will determine gain or loss by reference to simulated net book value, which, in turn, is determined after subtracting simulated depletion. 179

Special Considerations for Oil & Gas MLPs MLP Sale of Depletable Property As with the reporting of depletion, tax gain or loss from the disposition of oil & gas properties is not reported as part of the data reported on the face of Schedule K-1. 180

Special Considerations for Oil & Gas MLPs MLP Sale of Depletable Property Rather, when an MLP sells or disposes of an oil and gas property, the MLP does not compute the tax gain on the property. 181

Special Considerations for Oil & Gas MLPs MLP Sale of Depletable Property The MLP is required to allocate the amount realized from the sale to each unit holder and each unit holder uses his or her individual tax basis in the property to compute gain or loss on the sale. Section 613A(c)(7)(D). 182