In mid-October Linn Energy (LINE) created Linn Company (LNCO) to provide investors an alternative to the traditional MLP structure. LNCO assets will consist primarily of shares in LINE and is intended to track LINE in terms of distributions and price. The purpose is to allow investors to isolate which tax structure best meets their needs.
So, if one is looking to invest in Linn Energy, quite simply, which one should they choose?
First, let me say that for those desiring to invest their IRAs or ROTHs choosing LNCO over LINE is a no-brainer. The reporting and tax issues surrounding MLPs are draconian. So, let's look at which entity is preferable in taxable accounts.
A quick summary of the tax structure differences is appropriate:
LINE: Quarterly distributions consist of two components...1) Net earnings, taxed at ordinary rates and 2 )Return of Capital (RTC), not currently taxed. Though the proportions will change over time, currently about 80% is RTC.
LNCO: Quarterly distributions are taxed as dividends, subject to the current favorable dividend rates.
LINE: Proceeds on sale consist of 1) Basis (reduced by RTC), 2) Recapture of previous RTC, taxed at ordinary rates and 3) Capital Gains.
LNCO: Proceeds on sale consist of 1) Basis and 2) Capital Gains.
The net outcome is that the MLP structure defers current tax on most of the distributions, but then incurs ordinary income instead of capital gains rates upon disposition. LNCO, on the other hand, subjects distributions to current taxation, presumably at lower rates. If we tried to evaluate either structure on just this basis we would have a daunting task.
My previous article (here) attempted to analyze these two different tax structures. In order to so, it assumed tax law would remain fixed. Based upon this "static environment" it concluded that under most scenarios, traditional taxation was preferable to MLP taxation. It came down to paying lower taxes now versus higher taxes later.
Quite frankly, I think it is impossible to reach a conclusion based only on tax factors. It is uncertain what tax rates will be in the future and if dividends or capital gains will continue to be favored and to whom. Even if the "fiscal cliff" tax issues are resolved soon, it provides no guarantee of what the future holds.
Even though an accurate tax analysis is nearly impossible, I firmly believe that the different tax structures create a fundamental difference that favors LNCO. Though the share price of LNCO is intended to track LINE, over time it is unlikely to do so. Sure it will go up or down as LINE does, but LNCO will likely outperform LINE.
My reasoning is based on market basics. Share prices of each company will be independently driven by its own supply and demand. IRA investors seeking exposure to this company will certainly choose LNCO over LINE. Existing IRA unit-holders can sell their holdings in LINE and purchase LNCO and this may already have started.
Institutional investors have shied away from MLPs but may favor LNCO as a traditional form to LINE in MLP form.
Here's a graph showing the relative performance of LNCO and LINE since LNCO's inception.
Conclusion: Current tax regulations seem to favor LNCO over LINE. If ordinary rates go up more than dividend and capital gains rates, then LNCO's advantage will advance. On the other hand, dividend and capital gains rates may rise faster than ordinary rates for high-income earners. For that matter, anything (including taxation of MLPs) can happen.
It is impossible to determine whether LNCO or LINE is the better investment based solely on tax issues. LINE seems to have more potential for bad things to happen, but only the future will tell.
Instead of looking solely to tax issues, we need to look to any other factor that might distinguish one over the other. It seems to me that LNCO will more likely attract a disproportionately higher amount of interest than LINE. That should drive its price higher, relative to LINE.
Disclosure: I am long LINE.