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Vanguard Natural Resources And Cancellation Of Debt Income (CODI)

|About: Vanguard Natural Resources, LLC (VNR), Includes: ROAN
Summary

SA author, Wyco Researcher, wrote an excellent article on the potential implications stemming from Vanguard Natural Resources' bankruptcy filing.

He briefly mentioned the topic of CODI. Given the amount of commentary regarding this topic, this is my attempt to arm investors with more information on the topic.

I found four excellent articles that better explain the topic. However, I strongly urge affected investors to consult with their tax professionals.

Seeking Alpha author, Wyco Researcher, wrote an excellent recent piece on Vanguard Natural Resources, LLC's (NYSE:VNR) bankruptcy filing. Wyco has written a number of very in depth articles about bankruptcy and has kept investors abreast to obscure court document filings, in a timely fashion, as firm's in his coverage universe navigate through bankruptcy. Since I am a credit analyst in the oil industry, I follow upwards of eighty companies and I get Seeking Alpha's excellent real time breaking news email alerts. Moreover, as many of Seeking Alpha readers seem to either express a strong interest in oil and gas Master Limited Partnerships (NYSEARCA:MLPS) or actually own a number of these securities in their investment portfolios, now is a good time for me to write about Cancellation of Debt Income "CODI".

I would argue that the vast majority of investors in these securities have either never hard of the term "CODI" or simply don't fully understand its implications. To that end, I did some research with the goal of providing more information to investors that may be affected by CODI.

If with look at VNR's FY15 10-K there are two disclosures that mention the risks associated with CODI. Now that VNR has formally filed for bankruptcy and has filed its intentions for discharging some of its debts through the bankruptcy process, I am going to copy their specific risk language below. Enclosed below are the risk factor that can be found on page 50.

Our unitholders are required to pay taxes on their share of our taxable income, including their share of ordinary income upon cancellation of a portion of our debt, even if they do not receive any cash distributions from us. A unitholder's share of our taxable income, gain, loss and deduction, or specific items thereof, may be substantially different from the unitholder's interest in our distributable cash flow

Because our unitholders will be allocated taxable income that could be different in amount from the cash we distribute, they will be required to pay any federal income taxes and, in some cases, state and local income taxes on their share of our taxable income, whether or not they receive any cash distributions from us. Our unitholders may not receive cash distributions from us equal to their share of our taxable income or even equal to the actual tax liability that results from their share of our taxable income. As of February 25, 2016, we have suspended all cash distributions to unitholders and monthly cash distributions to holders of our preferred units. We may engage in transactions to de-lever the Company and manage our liquidity that may result in income and gain to our unitholders. For example, if we sell assets, our unitholders may be allocated taxable income and gain resulting from the sale. Further, we have in the past engaged in, and may in the future engage in, debt exchanges, debt repurchases, modifications of our existing debt, or similar transactions that resulted in, or could result in, "cancellation of indebtedness income" (also referred to as "COD income") being allocated to our unitholders as taxable income. Unitholders may be allocated gain and income from asset sales and COD income and may owe income tax as a result of such allocations notwithstanding the fact that we have currently suspended cash distributions to our unitholders.

For example, our issuance on February 10, 2016 of approximately $75.6 million aggregate principal amount of new Senior Secured Second Lien Notes to certain eligible holders of Senior Notes due 2020 in exchange for approximately $168.2 million aggregate principal amount of the Senior Notes due 2020 has resulted in the COD income that will be allocated to our unitholders as of February 29, 2016. Some or all of our unitholders may be allocated substantial amounts of such taxable COD income, and income tax liabilities arising therefrom may exceed cash distributions. The ultimate effect to each unitholder will depend on the unitholder's individual tax position with respect to the units; however, taxable income allocations from us, including allocations of COD income, increase a unitholder's tax basis in his units.

A unitholder's share of our taxable income and gain (or specific items thereof) may be substantially greater than, or our tax losses and deductions (or specific items thereof) may be substantially less than, the unitholder's interest in our distributable cash flow. This may occur, for example, in the case of a unitholder who owns units in the month in which the cancellation of debt occurs or a unitholder who acquires units directly from us in exchange for a contribution of property whose fair market value exceeds its tax basis at the time of the contribution. Unitholders are encouraged to consult their tax advisors with respect to the consequences of potential transactions that may result in income and gain to unitholders.

Here is another brief mention of the topic on page 34.

Further, to the extent that we enter into additional transactions which result in the discharge of debt at a discount, the holders of our common units may be subject to income tax to the extent the cancellation of indebtedness income exceeds cumulative passive losses generated by Vanguard in prior years, if applicable.

As this is a complex topic that is really best suited for a tax expert with an in depth knowledge of MLPs, I am going to provide links to other articles that shed light on CODIs. On February 16, 2016, during the depths of the oil crash, the law offices of Latham & Watkins wrote a piece: Restructuring Oil and Gas Partnership Debt? Tax Planning Is Key.

Here is an important excerpt from Latham & Watkins' piece. I highly encourage readers in this situation to read it.

MLP investors are familiar with the concept of a "tax shield," which is often associated with an investment in MLP common units. As partners in an MLP, common unitholders receive allocations of income, gain, loss and deduction with respect to their units. Non-cash deductions, such as depreciation and depletion, often lower the net income allocated to these unitholders to an amount less - in many cases substantially less - than the cash distributed to them. These "excess" cash distributions instead reduce a unitholder's basis in his or her units, effectively resulting in tax deferral. But, just as non-cash deductions can defer a current tax liability, non-cash income can accelerate it, creating "phantom income." Simply put, phantom income results in a cash tax liability without a sufficient distribution of cash with which to pay the tax bill. When a partnership has non-cash income, such as CODI, the partners are allocated phantom income. Although the partners receive additional basis in their partnership interests as a result of the income allocation, they often cannot offset the CODI, even if they were to sell their partnership interests at a loss, due to the character mismatch - the CODI is generally ordinary income whereas the loss is generally a capital loss, and capital losses can only offset capital gains.

The Wall Street Journal has also had a pretty good coverage of this topic. They have discussed Linn Energy, LLC's (LINEQ) massive bankruptcy and legal maneuvering to help investors try and avoid CODI consequences. If interested, you can read:

MLP Investors' Maze of Tax Trouble Keeps Getting Worse (WSJ - March 31, 2016)

Per Laura Saunders' WSJ piece (linked above), even investors that own these securities in tax deferred accounts can be affected.

Investors holding Linn units in an IRA or Roth IRA could also face tax bills on the exchange of units for shares. To prevent abuses, the law imposes a special levy on certain partnership income if the total in all IRAs exceeds $1,000 a year. Even if investors holding MLPs in an IRA haven't owed this levy on their annual payouts, a sale of units could come with a tax, Mr. Greenwald said. Capital losses within an IRA aren't deductible, he said.

While many IRA owners are unaware of these rules, IRA custodians are charged with enforcing them-and some are watching more closely than they have in the past. Last year Pershing filed tax forms for about 5,000 investors holding Kinder Morgan Energy Partners in IRAs after its 2014 restructuring. Fidelity Investments has announced additional oversight of partnerships in IRAs for 2016.

The WSJ also wrote a different March 9, 2016 piece, again referencing Linn Energy, describing how investors are affected by the CODI issue and how Linn was scrambling for a legal miracle to shield investors from the double hit of capital losses for their equity investors as well as CODI liabilities.

MLP Investors Face Tax Hit On Top of Big Losses - (WSJ March 9, 2016)

I also want to share a link to one other excellent article: Bankruptcy and the Cancellation of Debt, published in Oil and Gas Investor on February 29, 2016. Authors from Haynes and Boone LLP shares detailed analyses. Here is some excerpt discussion exceptions to the CODI rules. I highly encourage readers to review the article.

Although there are these two important exceptions to the CODI rule, in the case of a pass through entity, these exceptions are applied to the entity's owners (i.e., at the owners' level), and not at the entity level. So if the pass through recognizes CODI in connection with its bankruptcy, the bankruptcy exception doesn't apply to protect the owners when this income is passed through to them. In the example above, if a bank loans an MLP $1 million and later agrees to accept $600,000 in full payment of this indebtedness, then the MLP will recognize $400,000 as CODI, the $400,000 CODI is then passed through to the MLP's owners, and the exceptions to recognizing the CODI are applied at the owner level. In other words, is the owner either bankrupt or insolvent when the event causing the CODI occurred? If the answer is no, then these exceptions do not apply, and the income is includable in the owner's tax return giving rise to a tax liability without any cash distribution to pay the tax liability.

Takeaway

I am not an MLP tax expert nor a tax professional, so this article and its cited sources are merely additional information that readers possibly affect by Vanguard's bankruptcy may need to better assess their situation. Moreover, given the strong popularity of MLPs as an asset classes, it is important that all investors speak with their tax professional, so they don't get surprised by a CODI tax situation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.