Is LinnCo In Trouble?

| About: Linn Energy, (LINEQ)

Summary

LinnCo could be hit with a huge tax bill.

This is a result of Linn Energy’s debt exchange and repurchases.

However, LinnCo is left with not much cash coming in due to Linn Energy’s distribution suspension.

What is LinnCo?

LinnCo Linn Energy (LINE) created LinnCo (LNCO) back in 2012 in order to appeal to income investors who were uninterested in investing in MLPs/LLCs due to tax-reporting reasons. LinnCo does not issue a Schedule K-1 for taxes nor does it pay distributions like Linn Energy. Rather it reports on a 1099-DIV and pays dividends, a much easier form to fill out for most investors.

LinnCo does not own any physical assets, only Linn Energy units. When Linn Energy was still paying cash distributions, LinnCo also paid a cash dividend equal to that amount. In other words, LinnCo was Linn Energy's dividend paying proxy.

Berry ruined LinnCo

The secondary reason LinnCo's creation was to give Linn Energy another form of equity funding that it can use to acquire C-corps. The vast majority of LinnCo shares were created when Linn Energy bought out Berry Petroleum in an all-stock transaction.

Though, since that deal closed, shares of LinnCo has consistently traded at a wide discount to units of Linn Energy. This was largely a result of too much equity being issued for a relatively unknown name. In addition, As of 9/30/2015, LinnCo owned ~37% of all Linn Energy 355.0 million units outstanding.

Linn Energy bond exchange tax bill

Now that we understand LinnCo's structure, the following note from a recent Linn energy Press release is extremely worrying.

Estimated Tax Characteristics of 2015 Cash Distributions and Estimated 2016 Cash Tax Liability

LinnCo and Other Unitholders of LINE Estimated 2016 Cash Tax Liability

Unitholders of LINE are required to pay taxes on their share of LINE's taxable income, including their share of ordinary income and capital gain upon dispositions of properties by LINE or cancellation of debt, even if they do not receive any cash distributions from LINE. For example, LINE's 2015 senior notes exchanges and repurchases of outstanding senior notes at prices lower than face amount resulted, and any similar transactions in the future will result, in the cancellation of debt income that will be allocated to LINE unitholders.

Could LinnCo be hit with a tax bill from Linn Energy bond exchange and repurchases? According to the SEC filings, the answer to this question appears to be yes.

We are required to pay taxes on our share of LINN Energy's taxable income, including our share of ordinary income and capital gain upon dispositions of properties by us or cancellation of debt, even if we do not receive any cash distributions from LINN Energy.

...

For example, LINN Energy's previously announced repurchases of approximately $783 million of its outstanding senior notes at prices lower than face amount have resulted, and any similar transactions in the future will result, in the cancellation of debt income that will be allocated to LINN Energy's unitholders, including us.

Some or all of LINN Energy's unitholders may be allocated substantial amounts of such taxable income, and income tax liabilities arising there from may exceed cash distributions.

In addition, LinnCo is required to pay this even though Linn Energy has stopped paying cash distributions to it.

We are required to pay federal income taxes and, in some cases, state and local income taxes on our share of LINN Energy's taxable income, whether or not we receive any cash distributions from LINN Energy.

We may not receive cash distributions from LINN Energy equal to our share of LINN Energy's taxable income or even equal to the actual tax liability that results from our share of LINN Energy's taxable income.

How big is this tax bill?

Combined, Linn Energy saw ~$1.23 billion of its debt canceled via these transactions. This will result in a large amount of cancellation of debt income for LinnCo. As it owns 37% of Linn Energy, this would be a gain of around $455 million.

While LinnCo will receive deductions from its ownership of Linn Energy units, the tax bill from the debt exchange and repurchases could be substantial. A 30% tax rate would ~$137 million, greater than LinnCo's current market cap.

Keep in mind that the ultimate tax bill, if any, will not be known until the year end report is out for both companies and will likely take until Linn Energy files it Schedule K-1.

Who will pony up the cash?

The SEC filings are unclear on this point:

If we were to have a tax obligation, we may not have enough cash reserved or other liquidity to meet that obligation, in which case we would have to rely on LINN Energy to provide us with cash to pay any such tax obligation. LINN Energy is not required to pay our income taxes.

In other words, LinnCo would rely on Linn Energy. But at the same time Linn Energy is not "required" to pay LinnCo's income taxes.

Keep in mind that Linn Energy has very little liquidity-- it was relying on the credit facility as of 9/30/2015, though should see excess cash flows post distribution suspension.

Though, at the same time, LinnCo will have no cash incoming from its ownership of Linn Energy units. This is not a good position to be in.

Conclusion

With Linn Energy seemingly handling its unitholders a huge tax bill, the outlook for LinnCo has become much more cloudy. Frankly, it appears LinnCo is close to insolvent without the distribution income and with this pending liability. Though, I think it is more than likely Linn Energy would bail out LinnCo if it came to that.

One final note -- I am a writer, not a tax professional and cannot offer tax related advice. Cancellation of debt income is a fairly complicated topic and is beyond the scope of this article. Always consult a tax professional regarding your specific tax situation.

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