Linn Energy: Time To Sell Or Exchange The Units

| About: Linn Energy, (LINEQ)

Summary

Linn appears to be headed to a restructuring that will leave its common units and common shares worthless.

Linn needs to eliminate around $5 billion in debt to get leverage down to a reasonable level for $70 oil and $3.50 natural gas.

The restructuring will likely result in a massive amount of cancellation of debt income being allocated to unitholders.

In a worst case scenario, the resulting taxes could be over 14x Linn's current unit value.

In general, selling the units is the least risky option. Holding or buying the units could be result in over 100% losses. Consulting a tax expert is very advisable though.

Linn Energy (LINE) has offered to exchange outstanding common units for shares of LinnCo (LNCO). In conjunction with other previous moves, this appears to be the precursor to a debt restructuring that will probably leave both LINE and LNCO worthless. The exchange is needed to protect unitholders from being assigned a massive amount of cancellation of debt income [CODI] that could result in a major tax bill. In general it appears that it would be best for unitholders to either sell the units (if one believes that common equity will be worthless after a restructuring) or exchange the units for shares (if one believes that the common equity will still have some value after restructuring). Holding onto the units would result in a significant tax bill in many (but not all)situations. The exact implications of a move to hold, exchange or sell will vary depending on one's tax situation, so it is recommended to consult a tax advisor. Additional details about the exchange offer can be found here.

Making A Viable Company

Linn Energy probably needs to reduce its net debt by $5 billion for it to be a viable company in the long-run without further debt reduction. Reducing its net debt by $5 billion should get its leverage ratio under 3.5x at $70 oil and $3.50 natural gas. This is still a fairly high leverage ratio considering that oil and gas prices have a long way to recover to get to those levels and may end up settling below $70 and $3.50 for a prolonged period of time. However, with that level of debt reduction I can see Linn having a chance to survive without additional debt reduction.

Common Units/Shares Will Likely Have No Value

Most of the evidence points to Linn Energy's common units or LinnCo's common shares having no value in the end. Linn's recent moves such as maxing out its credit facility borrowings (just before a substantial borrowing base reduction is likely to occur) and skipping its bond interest payments are the precursors to a debt restructuring. The debt restructuring will likely result in Linn Energy's common units being cancelled, as it is hard to envision wiping out $5 billion in debt and leaving some value for current common unitholders.

Reducing debt by $5 billion would trigger massive CODI, which would likely result in LinnCo filing for bankruptcy. LinnCo mentioned that "any such CODI allocated to LinnCo with respect to LinnCo's LINN Energy units may either cause LinnCo to reduce LinnCo's tax attributes or to have a cash tax liability." LinnCo already has a shortfall with $30 million in income taxes payable and only $11 million in cash. The CODI will likely result in a major increase in LinnCo's income taxes payable, with no ability to pay it. LinnCo's assets would also consist of Linn Energy units that would presumably be worthless. Linn's filing indicates that the CODI is likely to be triggered in May or later, so if that is the case selling/exchanging the units in April or before should result in avoiding any CODI allocation related to the 2016 restructuring. A Chapter 11 filing itself does not result in an allocation of CODI, but the implementation of an associated restructuring plan would. So Linn may file for Chapter 11 in April, but the restructuring plan would likely not be implemented until May or later.

Tax Implications

As I think that Linn Energy's common units and LinnCo's common shares will have no value due to the probably restructuring, the best course of action would be to just sell the units/shares right now. If one believes that the current common equity will retain some value post-restructuring, it would probably make most sense to exchange Linn Energy common units for LinnCo common shares, otherwise the tax hit could be quite prohibitive. There may be individual tax situations where continuing to hold Linn Energy common units may be okay even with substantial CODI, but I would certainly encourage investors holding Linn Energy common units to consult a tax advisor. This is especially true if one owns a substantial number of Linn Energy common units.

I will go through some information about the tax implications here below. These are just general examples and I am not a tax expert, so I do highly recommend consulting a tax expert about one's individual situation.

As an example, if a unitholder owns 100,000 Linn Energy common units, and Linn reduces its debt by $5 billion, the CODI allocated to that unitholder would be approximately $1.417 million. That is treated as ordinary income, so that could increase taxes by $561,000 for units that are currently worth only $40,000. Passive losses may be used to reduce the offset some of the ordinary income, but it seems likely that there would still be a massive tax bill in this case.

If the unitholder then sells the common units (or if the restructuring results in the units being cancelled), there would be a major capital loss (since the CODI would be added to the cost basis of the investment). If the average unit cost was $5, the capital loss could be $1.917 million. This can be used to offset capital gains, so if the unitholder has a large amount of capital gains, the situation may not be too bad. However, if the capital loss needs to be applied against long-term capital gains, it could be quite costly as the top marginal rate for ordinary income is 39.6% versus 20% for long-term capital gains. So the unitholder would be paying 39.6% tax on the CODI and only being able to use it to offset gains that are being taxed at 20% (resulting in incremental tax of approximately $278,000 in this case).

If the capital loss is greater than the capital gains, then up to $3,000 of the capital loss can be used to offset ordinary income. If one only owns a small number of Linn units, the CODI may not result in larger tax bill in 2016 because of this. However, if one owns a larger number of Linn units and have capital gains that are less than the CODI, then one is faced with a large tax bill for 2016, with the potential ability to recoup the majority or all of the taxes over an extended period of years.

Also of note is that holding Linn in a retirement account could result in a significant tax hit as the CODI appears to be treated as Unrelated Business Taxable Income [UBTI], which can result in the maximum tax bracket being reached at just $12,300.

Other Notes

Linn also mentions:

The IRS could potentially assert that the exchange should not be respected under various theories, and if such a challenge was successful, an exchanging LINN Energy unitholder could be allocated CODI upon a subsequent strategic transaction involving LINN Energy. While not free from doubt, LINN Energy and LinnCo do not believe that such challenges would be proper, but no assurance can be made regarding (1) whether the IRS would assert such challenges or (2) the outcome of such challenges.

Thus, the exchange may not completely eliminate the chance of CODI being allocated to the (former) unitholder. Although Linn believes the exchange will not meet with a successful IRS challenge, selling the units would appear to be the safest course of action if one wanted to avoid an allocation of CODI.

Conclusion

Linn Energy appears to be preparing for a restructuring that will most likely leave its common units and LinnCo's common shares worthless. With Linn needing to reduce debt by $5+ billion to be viable and a current market capitalization of under $150 million, I don't think anyone can truly believe that the current common units will retain any value in a restructuring. Worthless common units would also result in LinnCo's common shares being worthless.

The restructuring would also result in a significant allocation of CODI to anyone who still owned units at the time the restructuring was implemented. Depending on one's tax situation, the CODI could result in a tax hit for the 2016 tax year that is over 14x Linn's current unit price. Individual tax situations may mitigate some or all of the tax hit or allow for recouping it over a multiple year period, but the effect on cash flow could still be quite negative. It is important to be informed about the potential tax ramifications, so consulting a tax expert appears very advisable. I can envision people not paying attention to the situation, buying Linn units at $0.40 now and potentially ending up with a 1500% loss on their investment.

Disclosure: I am/we are short LINE.

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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