Williams Companies and Enbridge want investors in their master limited partnerships to exchange their units for corporate stock in a transaction that will trigger taxes for many

By Laura Saunders May 25, 2018 5:30 a.m. ET

Investors seeking both high income and low taxes poured billions of dollars into publicly traded energy master limited partnerships. Now many have tax headaches—surprisingly big bills from Uncle Sam and return preparers.

Two new MLP deals, from Williams Companies Inc.. and Enbridge Inc., ENB -0.60% are the latest to trigger these headaches. In these deals, known as roll-ups, the corporation sponsoring an MLP pulls it back into the corporate fold, and MLP investors exchange their units for corporate stock.

These consolidations will provide tax and other benefits to the parent corporations and their shareholders. Williams said that as a result of the deal, it expects not to owe cash taxes through 2024. But for these MLPs’ investors, the deals are taxable and neither one includes a cash payment to help with their own tax bills.

“In each case, the corporation and its investors will reap tax benefits at the expense of one segment of stakeholders,” says Robert Willens, an independent tax analyst.

A spokesman for Williams disagreed with this assessment, citing a premium to be received by MLP investors, among other things. A spokesman for Enbridge referred investors to the deal’s announcement.

These consolidations once again show the downside of the innovative MLP format. They were originally conceived as a way to attract investment to income-producing energy assets like pipelines. As partnerships, MLPs bypassed a layer of corporate taxes, and high depreciation plus special breaks helped defer taxes on hefty income payouts.

These features drew investors craving income, many of whom ignored MLPs’ tax complexities. Some planned to hold their units until death, when messy issues often disappear because of favorable tax provisions.

However, many MLP investors haven’t been able to hold that long. Some corporate sponsors cooled to MLPs when the structure became burdensome to growth. In 2014, Kinder Morgan Inc. consolidated two affiliated MLPs that were widely held by investors in a reorganization that was taxable to the investors.

The latest two hiccups for MLP investors both occurred on May 17. Tulsa-based Williams said it would acquire the remaining 256 million units of its affiliated MLP, Williams Partners . Investors will receive nearly 1.5 shares in the parent for each unit they own. Calgary-based Enbridge announced it would exchange company stock, in different ratios, for units of two affiliated MLPs.

The two companies both cited a March 15 ruling by the Federal Energy Regulatory Commission that denies a tax benefit previously allowed to MLPs. This reduces profits and further tilts the scales against the MLP format for some pipelines.

To be fair, MLPs have performed well for many investors. But when units must be sold, the act of selling often brings a complex and costly reckoning with the Internal Revenue Service. “In the end, many MLP investors don’t do as well as they expected to,” says Mark Cook, a CPA with SingerLewak in Irvine, Calif.

For those facing an MLP roll-up, here are tips for the road ahead. Determine the cost. The starting point for measuring an investment’s taxable gain or loss is its purchase price plus adjustments, known as “cost basis.” With a stock this is often the purchase price. But figuring the correct basis for partnerships such as MLPs is usually complex because they pass income and deductions directly through to their investors.

This means that MLP units often have many adjustments to their purchase price. For example, income raises a unit’s cost basis, while depreciation and losses lower it. The partnership reports annual adjustments to investors on a Schedule K-1—be sure to keep these records.

Tracking adjustments is often tedious. A spokesman for Williams said that a calculator on its website can help determine results through 2017, but it doesn’t yet include results for 2018. Figure the gains or loss from the sale. The investor’s net results can include both profits and losses.

Net profits are typically taxable as capital gains, which can qualify for lower rates, or as ordinary income, which is usually taxed at higher rates. Losses are generally capital losses.

After an MLP sale, say Mr. Willens and Mr. Cook, some investors wind up with an unwelcome tax result: large gains taxed at higher ordinary income rates, and capital losses that can’t be used to offset them.

Don’t donate. Some investors dealing with MLP complexity look to donate units to charity, as they would a long-held stock. This strategy seldom makes sense. Unlike with stock shares, the donor usually can’t deduct the full market value of the MLP units.

Cope with IRA issues. Tax specialists warn against putting MLP units in individual retirement accounts or Roth IRAs, because certain income could be taxable even though the account is tax-exempt. Many investors don’t owe this levy annually because the taxable income falls below the limit of $1,000 per IRA.

However, a sale of all MLP units held by an IRA could trigger substantial taxable income for IRA owners, says Mr. Cook.

Settle up. In addition to tax due, the IRS requires a special statement from MLP investors in the year of a sale, breaking out capital gains and ordinary income earned. Janet Hagy, a CPA in Austin, Texas, warns that tax-prep software often lacks the proper form.

She adds that preparing taxes for MLP units is so time consuming that investors should expect tax-prep bills to rise by 200% to 300%.

Write to Laura Saunders at [email protected]