Linn Energy Vs. LinnCo: And The Verdict Is...

| About: LinnCo, LLC (LNCOQ)

The complexity of things - the things within things - just seems to be endless. I mean nothing is easy, nothing is simple. - Alice Munro

In my recent article I made some comparisons between Linn Energy (LINE) and its non-MLP offshoot Linn Company (LNCO).

There are many complexities in the financial arrangements concerning both entities. This article will try to simplify the arrangement in order to explore a little recognized, yet extremely important, tax differential.

I struggled with going into the differences without recapitulating the taxation of MLPs. In the end, I think it best to lay them out, so we can draw appropriate conclusions. If you are comfortable with how MLPs are taxed, then you may want to skip down to the Comparative Difference section of this article.

LINE is taxed as an MLP. This structure causes distributions to have unusual characteristics. Each distribution consists of several "tax components". They could be taxed, in whole, or in part, as ordinary income, non-taxable Return of Capital [ROC] or capital gains.

The first step requires understanding the source of any distributions you received. Simply stated, the distributions are made from either Free Cash Flow, Financing, Dilution or Asset Liquidation. Free Cash Flow [FCF] is net earnings after expenses but before taking allowances for depreciation and depletion (D/D)

Let's say LINE has $10/unit of FCF and decides to distribute all of it to the unit-holders. The question is, how much, if any of this, is taxed and at what rate?

To answer this we need to go a little deeper. Let's say LINE actually earned $10, net of expenses and that D/D was $9/unit. So, for tax purposes LINE had net, taxable earnings of $1/unit ($10 earnings less D/D). So, your K-1 will report that $1 and you will pay tax at ordinary income rates on that $1. If LINE is in an IRA, this $1 is your UBTI (with a few minor adjustments).

In actuality, the K-1 reports the $1 as taxable in a round-about way, with pluses and minuses on various lines. So the K-1, line 1, may be more or less and the other lines make adjustments to get back to the $1, net. The remaining $9 is considered a return of capital and you pay no tax, but it reduces your basis by $9. This is important, because in future years, when you sell, your gain will be (for tax purposes) figured on your adjusted basis.

If you have owned LINE for many years, the annual distributions may have reduced your basis to zero. When this happens, future $9's lose their tax free feature and, instead you pay capital gains tax on the $9. Now, it is possible that in any given year, FCF will still be $10, and the distribution will still be $10, but the D/D allowance will be, say, $12. In this situation you will show a $2 loss.

This is a passive loss and cannot be deducted, currently, against anything. It is a "suspended loss". It can be deducted from LINE's future years taxable income, or carried forward until you sell your entire interest. However, the suspended loss can only be deducted against gains from LINE. When and if you sell any shares, we need to deal with recapture. Remember the depreciation/depletion allowances that shielded $9 of earnings from taxation? Well that "shield" was only temporary. When you sell your units, you have to bring back into income the depreciation/depletion allocated to your sale. This recapture is taxed as ordinary income, not capital gains. And, yes, if you held the MLP in an IRA, it's subject to UBTI.

Over the years, your D/D could be as much as 80% of your cumulative distributions. That means the recapture can be quite sizeable, and not something to be taken lightly.

Comparative Difference: LINE is taxed as an MLP and LNCO, through a complex arrangement, is taxed in a fashion similar to regular corporate stock. LINE owns pipelines, drilling equipment and other assets that create income. LNCO, on the other hand, owns only an interest in LINE and receives distributions from LINE. When LNCO receives distributions, they have the same characteristics as if you owned them ----Income, Return of Capital and Capital Gains.

Now, when LNCO makes distributions, they are considered dividends and subject to taxation as such. Let me now bring in an unusual treatment of LNCO's dividends that hasn't been widely publicized.

In 2012, LINE showed a net loss. That means that when LNCO realized its distribution from LINE, it does not create any current taxable income to LNCO, but, instead a passive loss (just as you would have, if you owned LINE).

According to the Code, dividends can only be paid out of current earnings or prior years accumulated earnings. Well, if LNCO doesn't have any...what then? Enter the non-dividend distribution. This is exactly what its name implies. Under the Code, such a distribution is considered Return of Capital . That means it will have the same non-taxable treatment as would a corresponding distribution from the MLP-LINE. And, just like its MLP-LINE counterpart it will reduce basis.

A big difference between LNCO and its MLP-LINE counterpart, is that when you sell shares in LNCO any gains resulting from the fact that your basis has been reduced is Long Term Capital Gains and you will not be exposed to recapture. What if in a given year LINE's distribution is part earnings and part ROC. Well, when LNCO recycles that distribution to you, the part that would have been income is capital gains and the balance is ROC.

So, what we have, is that the LNCO distribution can mimic LINE's distributions Except that amounts that LINE unit-holders would report as ordinary income, LNCO shareholders report as capital gains. Oh, and of course, LNCO has no UBTI issues for IRAs.

As a result of all this, owners of LNCO can reasonably expect that each year they will pay a lesser tax than their LINE counterpart. Upon disposition, they will escape any recapture. As a "cherry on top", they won't have to struggle with K-1s.

Disclosure: I am long LINE, LNCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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