What Oil & Gas Investors Should Know About Master Limited Partnerships and Cancellation of Debt Income
Due to the downturn in energy prices experienced in recent years, the bankruptcy of companies in the oil and gas industry has unfortunately become a frequent headline. The bankruptcy process is complicated for all parties involved, which creates a ripe environment for unseen consequences and negative surprises. One such issue that has caught some investors off guard is the cancellation of debt income recognized by master limited partnerships.
Master Limited Partnerships
A Master Limited Partnership (“MLP”) is an alternative tax structure to the more common C-corporation structure. MLPs are limited partnerships that are traded on a public exchange. As limited partnerships, MLPs enjoy tax efficiency as a “pass-through” entity. Income is only taxed at the partner level, not at the partnership level. This contrasts with C-corporations, which must pay income tax at the company level and again on dividends paid out on the shareholder level.
In order to qualify for the MLP tax structure, a company must earn its income in certain activities, including businesses related to commodities and natural resources. As such, it is common to see energy companies employ the MLP structure. This includes upstream, midstream and downstream businesses.
Cancellation of Debt Income
If debt is forgiven or discharged in an amount less than what was owed, the debt is considered canceled in the amount that was not paid. The amount that was not paid is taxable in the year of cancellation, and Cancellation of Debt Income (“CODI”) must be reported on that year’s tax return.
However, there are exceptions that apply, which either disqualify the amount canceled as CODI altogether or exclude the CODI from gross income. Two exceptions seemingly most applicable to situations of MLP bankruptcy, which both serve to exclude the CODI from gross income, are the following:
- Debt canceled in a Title 11 bankruptcy case
- Debt canceled during insolvency
However, these exceptions will not apply to CODI in an MLP bankruptcy. Due to the “pass-through” nature of the MLP, these exceptions are applied at the partner level. So the partner must be bankrupt or insolvent in order to exclude the CODI from gross income. Although the MLP may be both in bankruptcy and insolvent, these exceptions do not apply at the partnership level.
CODI has been and still is a significant consequence of the MLP bankruptcies that have occurred in recent years. Income resulting from the cancellation of debt has been passed through the MLP to US taxpayers, who have gotten stuck with an unexpected tax liability due to this caveat in the tax code. It may be surprising that even with partnership equity zeroed out and distributions ceased, there can still be taxes allocated to unitholders from the bankrupt and/or insolvent MLP. Besides understanding CODI, it is important for an oil and gas investor to also:
- Understand the tax structure of the company in which they are invested
- If invested in an MLP, understand the partnership agreement, which will dictate how profits and losses are allocated to unitholders
- Read the company’s press releases. Often, the intent to restructure debt or, if necessary, enter into bankruptcy, will be signaled by management
- If the above point to the possibility of CODI, make the informed decision to hold or sell the units