Magellan Midstream Holders Face Big Tax Hit From Oneok Deal

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Magellan

Midstream Partners investors are getting a nice takeover premium in the pipeline operator’s merger deal with

Oneok
,
but many are likely to face hefty tax bills.

That reflects the partnership structure of

Magellan Midstream

Partners (ticker: MMP) and the treatment of its distributions. 

Oneok (OKE), a pipeline operator structured as a corporation, reached an $18.8 billion deal, including assumed debt, to buy Magellan in a cash and stock transaction initially valued at $67.50 per unit. That marks a 22% premium to Magellan’s closing price on Friday. The deal, disclosed Sunday, is due to close in the third quarter.

Magellan shares were up 14.3% on $63.28 Monday, just shy of the current value of the deal. Oneok stock was down 8.2% at $58.57. Magellan holders are set to receive $25 a share in cash and 0.667 of an Oneok share for each of their units. 

Magellan operates a large network of pipelines that carry gasoline and other refined products. It also transports crude oil.

Barron’s wrote favorably on the company three years ago, calling it one the “best run and financially astute pipeline operators in the country.” Due to their high yields, Magellan and other pipeline operators have been popular with retail investors. Before the deal, Magellan was yielding nearly 8%. 

The companies said the deal will be a “taxable event” for Magellan holders, and New York tax expert Robert Willens told Barron’s that the bill could be significant. For starters, the stock portion of the merger payment is taxable because while corporations can engage in tax-free reorganizations, partnerships such as Magellan can’t. The cash portions of takeover deals invariably are taxable.

“Not only is the deal fully taxable, it is a virtual certainty that most of the gain realized by the MMP partners will be ordinary income, rather than capital gain,” Willens wrote Barron’s in an email. “That’s because MMP has what are called ‘hot’ assets, and the portion of a partner’s gain from the sale of his or her interest that is attributable to the partnership’s hot assets is ordinary income,” Willen wrote Barron’s in an email. Hot assets are taxed at the rates for ordinary income, not capital gains, when sold.

Magellan holders, like those of other MLPs, receive distributions, which are the partnership equivalent of dividends. The outsize distributions are taxed lightly or not all initially, which is favorable to investors. The catch is that the distributions reduce the holder’s cost basis in the units, which defers taxes until the units are sold.

Given the tax structure, many

MLP

investors refrain from ever selling their units, which end up in their estates, where the tax treatment becomes advantageous due to the step-up in the cost basis at death. The Oneok transaction disrupts that because the acquisition represents a sale of those units.

In an email response to Barron’s about the tax issue, Magellan wrote: “The tax implication of the transaction will be unique to each investor depending on when they purchased their MMP investment. The $25 / unit upfront payment was negotiated specifically to help with the tax impact for our investors.”

Willens wrote that it is complicated for unit holders to compute their cost basis. “The basis is increased to reflect the partner’s distributive share of the partnership’s taxable income; and is decreased to reflect distributions made by the partnership to the partner,” Willens said. “Thus, a long-time holder of MMP units is likely to have very little basis remaining with the result that the gain from the sale of the partnership units will be correspondingly large.”

Moreover, the holder must reflect “the partnership’s non-recourse liabilities” of which the holder is being relieved.

“When it comes time to sell the units, their diminished basis in the units makes for a very large gain and, to add insult to injury, such gain is largely ordinary in nature rather than capital. We always have this reckoning when an MLP ‘roll up’ is taking place,” Willens wrote. 

MLPs go from being tax efficient to tax inefficient when they are sold. The result is that Magellan investors could face a tax bill that eats away much of the premium they receive in the deal.

Write to Andrew Bary at [email protected]