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Linn Energy - A Ticking Time Bomb

Summary

Linn Energy appears headed for bankruptcy.

The restructuring will create a huge amount of cancellation of debt income.

For unitholders who do nothing, the impact could be severe.

Should LINE or the SEC do more to educate holders on the risk?

Consult your tax professional.

It's not a secret that Linn Energy (NASDAQ:LINE) appears headed for bankruptcy. It's been demonstrated in various articles that it simply needs to restructure a substantial portion of its $9.3 billion of debt in order to continue as a going concern. That means a bankruptcy filing, whether in court or out of court, which will wipe out the value of the units. But that's not the reason LINE is a ticking time bomb. The reason it's a ticking time bomb is taxes.

LINE promises to be one of the most, if not the most, high profile publicly traded LLC bankruptcies in recent history. And I don't think it will be forgotten soon for many of unitholders.

Cancellation of Debt Income

Here is the problem. The reduction of debt (whether through an exchange for equity, reduction or cancellation) triggers cancellation of indebtedness income (CODI), which is includable in gross income unless an exclusion applies. The most important exclusion is Code Section 108, which provides that gross income does not include CODI that occurs while the taxpayer is insolvent. In a typical corporate bankruptcy, the corporation is the "taxpayer" and therefore the exclusion in Section 108 applies and no CODI is included in gross income. For a partnership or LLC, however, the "taxpayer" is the limited partner/unitholder, and therefore the Section 108 insolvency exception does not apply unless the limited partner/unitholder itself is insolvent. As a result, all CODI is allocated to the limited partner/unitholder in the case of a bankruptcy of a limited partnership/LLC.

If that sounds unfair, consider that partners/unitholders in partnerships/pass through LLCs such as LINE have been enjoying the benefits of the single layer of taxation during the good times; this is just the flip side of that advantageous tax treatment.

LINE Tax Implications*

By some estimates, LINE needs to reduce its outstanding debt by at least $5 billion. With 355.2 million units outstanding, that equates to around $14 of cancelled debt per unit, which results in $14 of CODI. Personally, I think that's actually at the low end and that they need to cancel more than $5 billion of debt, but let's go with that because it's a round number. That means for every 1,000 units you hold in this scenario, you are going to be on the hook for taxes on $14,000 of ordinary income. If you are at a 35% tax bracket, that's nearly $5,000 of taxes due as a result of the CODI on 1,000 shares, which are currently worth around $350. You may be able to offset that some with capital losses depending on your tax situation.

Taking the example further with bigger numbers - let's say you own 10,000 shares that are currently worth $3,500. In this example, that triggers $140,000 of CODI and around $50,000 of taxes due. Or let's say you own 100,000 shares worth $35,000. In this example, that triggers $1,400,000 of CODI and around...


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