If you own a piece of an energy limited partnership, you’ve suffered epic losses in recent months as .
Now, you may be in for a surprise tax bill as well.
Master limited partnerships, as these complex vehicles are known, are common in the energy industry. They’ve been around since the 1980s, but it wasn’t until recently that they took on star status among individual investors. (Pension fund investors usually steer clear of these partnerships because they create tax liabilities for them.)
Because these partnerships must distribute all of their excess cash flow to investors, their quarterly payments are generous. Regular savers whose fixed-income investments have been ravaged by the Federal Reserve’s zero-percent interest rate policy have found these entities’ payouts of 6 percent or more especially attractive.
Wealthy people, too, have flocked to United States partnerships for their tax advantages. Because they are not corporations, they pay no corporate taxes on the income they generate. Those tax bills were passed along to investors, resulting in a reduced overall tax rate.
A portion of these payouts represented a return of capital, reducing holders’ cost bases for tax purposes. When holders sell their shares, they pay a lower capital gains tax rate on any appreciation they have recorded.
The energy collapse brought a halt to the love fest between investors and these partnerships. Even after the bounce in oil prices earlier this week, the Alerian MLP index, a collection of 50 top energy partnerships, is down 47 percent over the last 52 weeks.
Now, the taxman may add to this burden.
Partnership investors face potential tax liabilities stemming from devastation in the oil patch.
The capital-intensive energy industry is laden with debt, and as limited partnerships have difficulty meeting their interest payments, they may try to restructure their obligations. When they do, partnership owners must pay income taxes on their share of the debt forgiven by creditors. These taxes are due even though unit holders received no actual income as a result of the restructuring.
“If these companies engage in workouts where some of their debt is forgiven, that would create what’s known as cancellation-of-indebtedness income,” said , a tax and accounting expert in New York City. He added, “Each partner would have income equal to their share of the cancellation.”
Consider the situation at , a troubled exploration and production company in Houston. After suspending its cash distributions indefinitely last fall, Linn announced a debt in November. Under the deal, the company exchanged $2 billion of its senior notes for $1 billion in new debt.
Linn, while not a master limited partnership, has the tax status of one. So the forgiveness of $1 billion in debt will result in a tax bill for its holders reflecting that amount.
The company’s documents warn investors about this situation. A spokeswoman for Linn declined to comment further.
This may not be the only restructuring deal Linn pursues. Earlier this month, it said it was exploring strategic alternatives related to its capital structure. The company had about $10 billion in debt as of last September, according to Fitch Ratings, and $345 million in cash.
Since individual investors’ tax positions vary, it is difficult to estimate what a particular Linn holder might owe. But Mr. Willens said that limited partnership investors would almost certainly be surprised when they got a tax bill for income they never received.
“We’ve never had this before in the world of M.L.P.s where they were in such trouble and had to restructure their debts,” he added. “This will be a first where these partners will have this income passing through to them.”
It’s hard to say how many partnerships will have to restructure their obligations. The price of oil will have great influence over that. But the amount of debt issued by energy partnerships has certainly been mammoth in recent years. At the end of 2015, some $258 billion in total debt was issued and outstanding at 105 of these partnerships tracked by Fitch Ratings. That’s up from $92 billion at the end of 2011.
“As the U.S. domestic energy production has been built out, there has been very strong demand” for M.L.P.-funded infrastructure, said Peter Molica, senior director at Fitch Ratings. “You’ve seen increases in equity and debt as these companies have built out their assets.”
While Mr. Molica acknowledges that the oil debacle has placed stress on the entire sector, he says the companies under the greatest pressure are those like Linn that pursue oil exploration and production, known in industry jargon as players in the upstream sector. Approximately 18 percent of the 105 partnerships Fitch tracks are in this business.
Far more numerous are partnerships in the so-called midstream sector — made up of companies that handle oil and gas transportation. Here, the stress is not yet as evident, Mr. Molica said.
“On the midstream side, we have a negative rating outlook but we don’t necessarily anticipate a huge bump up in restructurings quite yet,” he said.
At the moment, Fitch analysts expect defaults of 11 percent among high-yield energy issuers by the end of this year.
In addition to owing taxes on partnership income that they never received, long-term investors in these vehicles face a second potential liability when their companies restructure debt.
This one has to do with an investor’s cost basis, which declines from the initial amount invested as returns of capital are distributed. To the degree that a distribution received in a restructuring exceeds that cost basis, an additional tax will be levied, Mr. Willens said.
“You could get hit here from two sides,” he added. “For longtime holders, the bases have probably been written down pretty substantially, so the scenario isn’t that far-fetched.”
Prices of energy limited partnerships have been so beaten down that they are now being recommended again. And the almost 10 percent yield on the Alerian MLP index certainly looks inviting. But investors taking the plunge now should not be surprised if they hear later from the taxman.