As a result of an IRS private letter ruling (PLR 201907001) issued in 2019, a real estate investment trust (REIT) may now be an attractive alternative to the master limited partnership (MLP) structure for midstream energy businesses with pipeline and storage assets. For businesses that qualify, the REIT structure allows access to a broader pool of investors than an MLP, while retaining the core tax benefit of the MLP structure - no entity-level tax.

In recent years, the market perception of MLPs, whether rational or not, has made capital raising difficult and resulted in depressed unit prices for MLPs. A number of MLPs have abandoned pass-through tax treatment and converted to corporate tax treatment, a decision made somewhat easier by the decrease in the corporate tax rate to 21% beginning in 2018. FERC's 2017 decision to deny tax allowances to MLPs in cost-of-service rate cases provided further impetus for a number of midstream businesses to abandon MLP form.

An entity that meets the requirements for qualification as a REIT generally pays no entity level tax on its taxable income to the extent it distributes such income to its shareholders. Similarly, an MLP pays no entity level tax so long as it meets certain qualifying income requirements. However, because of favorable tax treatment to certain classes of investors and simplicity of tax reporting for all investors, REITs may offer an attractive alternative to the MLP form for certain midstream businesses.

The idea that a pipeline, storage or other midstream business could be organized in the form of a REIT is not a new one; there has been at least one midstream REIT (CorEnergy Investment Trust, Inc.) since 2013. There has not been widespread adoption of REIT structures in the midstream space, however, due to some uncertainty with respect to the IRS view of the relevant assets and income. With the recent IRS ruling and the exodus of many midstream companies from MLP form, REIT form, which offers the same key features as an MLP of both public trading and essentially one-tier taxation, needs to be considered.

REIT Tax Advantages

REITs offer certain tax advantages over MLPs which may make REIT investments attractive to a wider group of potential investors and, thus, enhance the ability of a midstream business to raise capital. These tax advantages include the following:

• Simplicity of Tax Reporting for Shareholders. Because REITs are characterized as corporations for tax purposes, their shareholders receive a Form 1099 reporting solely the amount of dividend distributions paid to them. REIT shareholders are not subject to the significantly more complex Form K-1 reporting applicable to MLP unitholders.
  
  
• Favorable Tax Treatment for Pension Plans, IRAs and Other Tax-Exempt Organizations. REIT shareholders that are tax-exempt organizations, such as pension plans, IRAs and endowments, generally are not subject to taxation under the unrelated business taxable income ("UBTI") rules on either REIT dividends or gain on the sale of REIT shares. In contrast, tax-exempt investors in MLPs are generally subject to tax on income and much of the gain from ownership or sale of MLP units.
  
  
• Favorable Tax Treatment for Foreign Investors. Foreign investors in a REIT are generally (i) not required to file U.S. tax returns as a result of investing in a REIT, (ii) not subject to tax on gain from selling REIT shares in many cases and (iii) subject to only a withholding tax on dividends (which may in certain cases be reduced under applicable income tax treaties). In contrast, a foreign investor in an MLP with a U.S. business is considered to itself be engaged in a U.S. trade or business for tax purposes and, thus, is required to file a U.S. tax return and is subject to U.S. income tax on its income and gain from ownership or sale of an MLP unit.
  
  
• No State Income Tax Filing Requirement or Tax Burden. A REIT shareholder generally does not have an obligation to file a state tax return other than in those states in which the shareholder is a resident or otherwise has nexus. By contrast, an MLP unitholder may be required to file returns in many states.

There is one tax advantage that MLPs have over REITs. The tax basis of MLP assets is stepped-up each time MLP units are bought and sold. The additional depreciation and amortization resulting from such tax basis step-ups typically results in taxable income allocations to MLP unitholders that are far less than the distributions they receive (i.e., a "tax shield"). Most or all of such tax shield is, however, recaptured as ordinary income when the MLP units are sold. Conversely, the tax basis of REIT assets is not stepped-up upon the purchase or sale of REIT shares, but there is no ordinary recapture income upon the sale of REIT shares.

Qualifying As A REIT

Both MLPs and REITs are vehicles designed to eliminate corporate tax at the entity level with taxation imposed only, or primarily, at the owner level. In the case of an MLP, the MLP generally is treated as a partnership and will not be subject to any entity level U.S. federal income taxation so long as at least 90% of its taxable income each year consists of certain types of qualifying income (generally, income from the transportation and storage of oil, gas and products thereof in the case of the midstream MLP). In the case of a REIT, the REIT must meet tests as to its income and asset composition (the most relevant of which are discussed below), must distribute 90% of its taxable income each year and must meet certain organizational requirements. If the REIT meets those tests and requirements, the REIT generally pays corporate level tax only on its undistributed taxable earnings. Put another way, if the REIT distributes all of its taxable income, there will be no entity-level tax on its earnings.

In order to qualify as a REIT, at least 75% of a REIT's assets must consist of real property or loans secured by real property and 75% of its income must consist of qualifying rents from real property, interest from mortgages on real property and gains from the sale of non-inventory real property or mortgages. Qualifying rent generally does not include income attributable to services provided to tenants other than those services usually and customarily furnished or rendered in connection with the rental of real property for occupancy or use only, unless the services are furnished by a taxable REIT subsidiary ("TRS") of the REIT or a qualifying contractor.

Recent IRS Letter Ruling on Midstream Activities

The determination that pipelines, tanks and terminals (and most of the components of same) held by a midstream business can be considered "real property" for this purpose has been established for a number of years. Accordingly, a traditional lease of such assets to a customer should give rise to income treated as "rents from real property." But what about the type of contract that is much more typical in the midstream business? A contract which is not set up as a lease but, instead, provides for the payment of fees or tariffs for transporting or storing product and ancillary services? It has been somewhat unclear as to whether and to what extent the fees received under these type of contracts would be considered to be "qualifying rents from real property."

In its recent private letter ruling, however, the IRS endorsed a taxpayer's treatment of its income as rents from real property even though its customer contracts took the form of typical service arrangements. Three types of facilities were discussed in the ruling: oil and gas storage facilities, oil and gas pipelines and an offshore oil and gas drilling platform. With respect to the pipelines and storage facilities, the ruling held that the fee income derived by the REIT from the long-term, dedicated capacity or minimum volume commitment-based pipeline and storage arrangements with unrelated customers constituted rents from real property. The key factors in the ruling were the following:

• The REIT itself provided transportation and storage, and was permitted to inspect, monitor, test, maintain, repair, provide security for and construct storage tanks and pipelines and other real property and to test product in the storage tanks solely to ensure the safety and integrity of the storage tanks and pipelines and the safety of the environment.
  
  
• The REIT formed, and paid arm's length compensation to, a TRS (which is subject to tax as a regular C corporation) to perform services including (i) loading, unloading, and moving product; (ii) adding agents or additives to product or blending products; (iii) taking samples of, measuring or weighing product for the benefit of the customer; (iv) heating and circulating product as necessary to ensure the stored product retains the appropriate physical characteristics; and (v) operating, maintaining, and repairing all compressors and all equipment used to heat, circulate, and blend the product.

Although a private letter ruling is directed solely to the taxpayer that receives it, the ruling provides an indication of the government's position on this issue; presumably a similarly situated taxpayer could obtain a similar ruling. Therefore, release of the ruling has opened the door for existing midstream businesses that might currently be structured as MLPs to qualify for REIT status, perhaps without the business having to materially change the nature of its customer contracts. Similarly, new midstream businesses considering an initial public offering may find that adopting REIT form is now a viable option.

There is another noteworthy difference between qualifying as an MLP and qualifying as a REIT: the products transported or stored by a REIT need not be limited to oil, gas, other natural resources and products thereof. In contrast, in order to meet the qualifying income test for publicly traded partnerships, the MLP's activity is typically restricted to transportation or storage of certain "natural resources" as defined for that purpose.

The REIT rules exclude from qualifying rental income the rent received from related parties. The reason for such a rule is obvious: without it, an entity could elect REIT status and form an affiliate, lease its operating assets that constitute real property and charge rent to its affiliate and eliminate entity-level corporate tax on that part of the operating income of the business that it receives as rent. Even with the IRS ruling's approval of contract income as rent, however, many existing MLPs could have a related party rent problem because they frequently earn a large part of their income from transporting and storing the products of their corporate sponsor. The rules regarding the determination of who is a related party for this purpose and the degree of permissible affiliation are somewhat complex but, with careful structuring, it may be possible to address even this problem in a REIT structure.

REIT Organization

REITs are usually organized as corporations or trusts and sometimes (for private REITs) as limited liability companies. REITs can be either public (publicly traded on an exchange) or private (non-traded and usually more closely held). A private REIT could be used as a means of attracting equity capital even if a midstream business does not want to be in the public markets.

Governance Considerations

REITs are required to be managed by a board of directors or trustees. As a result, most REITS tend to have a more traditional governance structure than that of MLPs which are usually controlled by a general partner that is separate from the MLP who has limited duties to the limited partners. The parameters of traditional corporate governance, with a board of directors elected annually by shareholders, are clear and well-known and, as a result, a REIT may confront fewer of the complexities raised by the partnership structure typical of many MLPs. On the other hand, the general partner of an MLP does have certain unilateral rights that are attractive to sponsors who desire to retain a large measure of control. The change in governance format would need to be carefully evaluated in any contemplated conversion.

What About FERC?

There is one problem MLPs are facing that the REIT structure may be unable to resolve. In 2018, FERC announced that, for cost-of-service based rates, it would no longer permit the recovery of an allowance for income taxes by pipelines owned by MLPs without a showing of an entity-level tax burden. Several midstream partnerships, in converting from MLP to corporate status, cited concern regarding this FERC position as the driver for their decision to change forms.

Although MLPs and not REITs were the focus of FERC at that time, FERC could raise the same question as to the entity-level tax burden with respect to REITs. As discussed above, REITs do not pay entity-level corporate tax if and to the extent that they distribute their REIT taxable income to their shareholders with the practical result that, similar to MLPs, they generally do not pay tax at the entity level. However, REITs are treated as corporations for tax purposes so, technically, they are subject to corporate level taxation that is only avoided by the REIT distributing out all its taxable income. Accordingly, an argument can be made that REITs could be distinguished from partnerships for FERC rate-setting purposes. An interstate pipeline REIT contemplating an IPO would have to market through this uncertainty.

Existing REITs as Buyers?

It is possible that we may start to see traditional REITs, such as infrastructure REITs, moving into the midstream space. The growth of the REIT industry in recent years has made REITs hungry for REIT-able assets and, according to NAREIT, in recent years, "non-traditional" REITs, such as data center, cell-phone tower, casino and billboard REITs, have accounted for over 20% of the total REIT market capitalization. Although any one REIT will tend to focus on a particular type of property, the tax rules do not impose a business-line restriction on REITs. For example, there is no prohibition on a shopping center REIT including apartment buildings or any other type of REIT-able assets, including midstream assets in its portfolio. Midstream assets may be diversifying additions to some existing infrastructure REITs. Therefore, even apart from the potential for MLPs to change to or use REITs as a structuring option, the acceptance of midstream assets as REIT-able may attract investment from established REITs.

Summary

Expect to see the midstream industry focus this year on the potential advantages of a shift to REIT structures.

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