Bankruptcy And The Cancellation Of Debt

By Kenneth Bezozo, Sam Lichtman and Don Shiman with Haynes and Boone LLP

Setting the stage – the background.

In 2012, Lenny P. invested in a publicly-traded MLP that, for federal tax purposes, is taxed as a partnership.  Each year Lenny received some healthy cash distributions from the MLP.  He also received an IRS Form K-1 annually from the MLP that showed his allocable share of the MLP’s income, gains, losses, deductions, etc.  Although the MLP allocated to Lenny his proportionate share of its income, the resulting tax liability was always less than the amount of cash distributions that Lenny received from the MLP, so Lenny was a happy investor.  But then in mid-2015 came the crash of oil prices and suddenly the value of Lenny’s MLP investment dropped precipitously, the pithy cash distributions from the MLP ceased and, of course, the annual Form K-1 still appeared.  However, Lenny decided to hold on to his MLP investment.  He thought, “Now is not the time to sell.”

What is an MLP and how is it taxed by the federal government?

An MLP is a master limited partnership, which is a business entity that is commonly used by oil and gas companies as an alternative to a regular corporation.  One of the advantages of an MLP is that the MLP’s income and losses are not taxed at the MLP level but, instead, are passed through to the owners of record (i.e., its investors), subject to the normal tax accounting rules that limit the ability to pass through losses such as the basis limitation, at risk and passive loss limitation rules.  In other words, an MLP is not subject to double taxation like a regular corporation (i.e., taxed once at the entity level, and then again at the owner level).  Because this type of entity is considered to be “tax efficient,” its use in the oil and gas industry has been pervasive in recent years.  (NOTE – there are some MLPs that are not taxed as a pass through entity because they elected to be taxed as a regular corporation.)    

If you live with a pass-through entity, you may wish you didn’t!

The requirement for the MLP to pass through items of income, etc. applies regardless of its or its owners’ particular circumstances.  For example, an MLP that is in bankruptcy is still required to pass through its income, losses, etc. to its owners.  Also, for example, if someone buys an MLP interest immediately before an event occurs that causes income to be recognized, that investor may be allocated its proportionate share of that income even though it receives no cash with respect to this income.

What is discharge of indebtedness income (a/k/a cancellation of indebtedness income or "CODI")? And how does it work in an MLP?

Under the U.S. Tax Code, when a debt is cancelled or forgiven for less than full payment the amount cancelled or forgiven is treated as income to the entity that owed the debt.  For example, 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.  But because the MLP is a pass through entity, the CODI is allocated among its owners in accordance with the MLP’s partnership agreement.  This means that because of the CODI, an owner of an MLP interest may receive an unexpected allocation of income without a cash distribution related to it.

BUT WAIT, isn’t there an exception to recognizing CODI in bankruptcy or due to insolvency?

There are a few important exceptions to the rule requiring the recognition of CODI, the most significant of which are the “bankruptcy exception” and the “insolvency exception.”  The bankruptcy exception basically provides that if the entity is bankrupt when the CODI occurs, then the income will not be recognized by the entity (i.e., it will not be included in the entity's income).  Similarly, the insolvency exception basically provides that if the entity is insolvent when the CODI occurs, then the income will not be recognized by the entity (i.e., it will not be included in the entity's income), but only to the extent of the entity's insolvency.  Insolvency basically means the amount that the entity's liabilities exceed the fair market value of its assets.

BUT WAIT -- the important exceptions to the CODI rules apply differently to pass through entities.  (As we stated at the beginning, if you live with a pass through, you may wish you didn’t!)

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.

The importance of the MLP's partnership agreement. 

Do not underestimate the importance of the MLP's partnership agreement.  It defines how income, losses, etc. are allocated among its owners.  For example, the partnership agreement may include special allocations of certain types of income to certain groups of partners and not to other partners.  Although this is not something an investor should count on to avoid an allocation of income that "is not fair to them," it could happen.

Should you rush to the "TAX EXIT?"  What are imminent warning signs? (The events that can cause a CODI event to occur)?

A CODI event most frequently happens when an entity is in bankruptcy, though it can also happen at any time that indebtedness is restructured leading to a partial or complete discharge of such indebtedness.  So if an entity has indebtedness, particularly a significant amount of indebtedness, that it cannot service or that is not reasonably proportionate with the value of the entity’s assets, then a debt discharge scenario becomes a real possibility.  Of course, another clear indication is that the entity files for bankruptcy protection or is involuntarily placed into a bankruptcy.  If any of these facts exist/occur, an owner can likely avoid the potential for a tax problem by disposing of its interest in the MLP before the occurrence of the CODI event.  In this regard, be aware that there are some tax accounting rules that may impact the allocation of income during the month that an owner disposes of its interest.

So, is that it?  Is there any good news to be had?

We guess it depends how someone defines “good news.” But the short answer is -- not really.  If an owner is allocated CODI by an MLP, this is treated as regular, ordinary income, which will increase the owner’s tax basis in its investment.  When the owner ultimately disposes of its interest in the MLP, the increased tax basis will reduce the amount of gain or increase the loss recognized by the owner with respect to this investment.  But if and to the extent there is a loss with respect to this investment, such loss will be a capital loss, only offsettable against capital gains (except for a de minimis amount).  This is not a good tax result in light of the fact that the CODI is ordinary income that is taxed at ordinary income rates.

Kenneth Bezozo and Sam Lichtman are partners and Don Shiman is an associate with Haynes and Boone LLP in its tax practice. They are based in the firm's New York office.