A Master Limited Partnership (“MLP”) is an investment vehicle used in oil and gas, and several other industries. MLPs are designed to avoid corporate level taxation; however, this comes at a price that many investors have not anticipated.
Before the downward spiral of the oil and gas markets, MLPs provided consistently high yields during a time of low interest rates. Certain MLPs used leverage to increase their feast time returns, such as Linn Energy and Breitburn Energy Partners LP.¹ Now that the domestic industry is facing an oil price induced famine, the leveraged MLPs are facing serious financial difficulties and are looking to restructure their debt—that is where the rub is.
MLPs are taxed as “flow-through entities,” so income, depreciation and other tax attributes are recognized by their partners without a corporate level tax. As the adage goes, nothing in life is free. One price for avoiding corporate level taxation is that an investor generally recognizes an MLP’s Cancellation of Debt Income (“CODI”).
What is CODI? When a lender forgives or restructures a borrower’s debt, the borrower has to recognize the benefit of that forgiveness or restructuring as taxable income. With an MLP, that means investors have taxable income even if the MLP didn’t actually pay any money out.
How bad could it be? According to a Lynn Energy release, if Lynn Energy receives $5 billion in debt forgiveness, it will allocate $14.17 of income to a $0.31 investment. In other words, if you invested $100 in Lynn Energy today, you could be allocated $4,570 of income without receiving a dime from your investment, which at a 33% tax rate would cost $1,508.
How do you avoid CODI? One way is to sell your investment in the MLP before the debt is forgiven. Unfortunately, this will be a sale (obviously). On the sale of an investment in an MLP, excess depreciation is recaptured as ordinary income, which means that you could have ordinary income on the investment as you sell the investment at a loss.
¹Based on our research, there are other leveraged MLPs, such as Atlas Resource Partners, LP; EV Energy Partner LP; Legacy Reserve LP; Memorial Production Partners LP; and Vanguard Natural Resources LLC.