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Eagle Rock Energy Partners, L.P. Message Board

  • ruby.thedyke ruby.thedyke Jul 25, 2010 6:27 PM Flag

    Research into tax consequences of rights

    I must confess my earlier thinking on this subject was dead wrong. I naturally started down the normal tax code analysis of rights distributions, Sections 301, 302, 305 and 307 of the Internal Revenue Code. Rights distributed are not taxable, but carry away basis from the underlying stock, and then there are further details from that point. Stock . . . oops, this is not a corporation, it's a partnership, taxable under Subchapter K. Forget the standard rules, we're in wonderland here, there is no statutory scheme in Subchapter K for this sort of transaction.

    The first question is whether anything was distributed at all when the rights were issued to the unit holders. Section 307 and the Regulations thereunder have a lot to say about stock rights, but Subchapter K has zip to say about rights to acquire partnership interests. Were they "property" at all?

    Take a closely held business as a example, just you and I, each owning 50% of the partnership. Suppose the partnership issues us rights to acquire additional interests in the partnership at a price below what might be the theoretical value of the interests if the partnership were to be sold. Has anything in substance occurred? Not if we act equally, we owned 50% before, we own 50% after, nothing happened except each of us made a contribution to partnership capital.

    But EROC is a publicly traded entity, and the rights had value on the public exchanges as securities in their own right. Counsel took the position in the prospectus (S-59) that the rights were property, and further as "marketable securities" under Sec. 731(c). I sympathize with their thinking, it does seem to meet the definition, even though 731(c) was written to cover the distribution of some other securities, not those of the distributing partnership. It treats the securities as cash, and since a dollar bill must always carry a dollar of basis by definition, the rights receive a full basis equal to their FMV when distributed.

    As to the tax consequences of the distribution of cash, that should be well known by anyone holding an interest in an MLP. Cash is a return of capital, not taxable unless it exceeds the basis of ones interest in the partnership. If the rights in this case are treated as marketable securities and therefore cash under 731(c), then they are no different than any other cash distribution by EROC.

    Next, what is the value of the rights? When and how is that determined? If this was a corporation, then Regs. Sec. 1.307-1(a) would provide that the value is determined on the day the rights are distributed to the stockholder, meaning that it could be possible that different stockholders could have different distribution days. Again, Subchapter K is silent in this regard, and counsel took the position in the prospectus that the value will be the weighted average trading price of the rights for the period that the rights are traded. I'm not sure what in the heck that means, are they suggesting all of June? On what basis? I think it should be the day they were distributed, June 1. Not everyone received their rights on that day, due to fumbling about by the brokerage systems, but the company is going to have to take a position on the K-1's, and is not about to inquire when every unit holder actually had the rights pop up in their accounts. I also agree with counsel regarding the weighted average calculation, which borrows from corporate code, but I have no idea how they intend to make this calculation, and we may not know (unless they choose to discuss it) until the K-1's are issued. Does anyone recall the opening trading range for EROCR on June 1 (which may not be correct per counsel)? It's too late to look it up, I tried on Big Charts and Yahoo.

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    • Alright, last problem, assuming you did exercise, what is the basis allocable to the units and warrants? That should follow black letter law, like any transaction at arms length, the cost is allocate to the assets purchased relative to their values at the time of the purchase. Counsel acknowledges that general rule of law at S-60 of the prospectus, but then takes a substantial leap of bad judgement by taking the position that the value of the warrants is equal to the weighted average trading price for the first 20 business days! Based on what?? It should be at the time you acquired the securities, the subsequent whims of the public markets should be irrelevant, what it the market crashed in those 20 days? I think they're crazy, but once again we're at their mercy, whatever position they claim will rule for the K-1's, and unless you plan on keeping a separately-tracked basis of your own (which is certainly possible), you're going to have to live with whatever the company comes up with.

      Guess what? If you acquired rights by purchase, you're going to have to do that anyway, because counsel admits on S-60 that it would not be possible for the company to know what you acquired the rights for, and they are not crediting your capital account for the purchase! Makes some sort of sense, that transaction was outside the partnership's books of course, but they can and do track your purchase price when you acquire actual units. It seems to me they could have setup a system where unit holders could have filled out a form with such information, but that's not in the cards. You're going to have to keep track of that extra basis, the company will not have it on the K-1's. What fun. No matter to me, I'm a retired tax professional who specialized in Subchapter K, and I keep track of my own unit basis anyway, so f 'em. But for the layman, and for H&R Block users, I foresee a lot of cost basis being left on the table in some future year.

      Finally, counsel discusses the forward tracking of unit basis at S-61, and notes you have the option of tracking by tranche or tossing it all in the same pot by default. I track by tranche, but that divorces you from the company's K-1 capital account system. I take account of all the basis adjustments that occur during the year and apply them to units on a per unit, per day basis using a spreadsheet, which is really not that big of a deal once you get it setup. Given my background, I actually regard such calculations as an amusement, and look forward to it. I can imagine others are already completely confused and will remain so. Blame Congress, they wrote Subchapter K (well, their staff did, but it's still their fault, the yacht owning, tax cheating bums).

      Questions? There will be a test on this material. Be sure to read pages S-59 through S-64, it will at least give you a sense of how uncertain all this is. Have fun!

    • So, what happens next, depending on what you did with the rights? If sold, there will be a gain or loss equal to the difference between the distribution value and the sales price. The gain or loss will be short term, since unlike a distribution of securities in a Subchapter C situation, the holding period will not "tack". Accordingly, there is no difference between someone who received rights for units already held, and someone who purchased rights on the public markets, the unit holder receiving the distribution will have been deemed to have received cash money and purchased the rights at FMV.

      What if you totally messed up and did not exercise? No sympathy from this quarter, but the tax consequences should be obvious, you were deemed to receive marketable securities equivalent to cash and lost them, a short-term capital loss. Surprisingly, counsel is apparently confused by their own logic, and at S-61 of the prospectus they propose that no loss would be recognizable, and the basis that would have flowed to the rights (as with any other cash distribution) would "recombine" with the their unit basis. Counsel admits there is no authority for their position, and I think they are thinking too hard, and made the same error I initially did, bringing Section 307 into a situation where it does not belong. In the Regulations there is a statement that seems to indicate a stockholder who receives rights and does not exercise has a zero basis in the rights. It's not a straightforward statement to that effect, but it's the logic of the language. But that has no place here. If counsel believes 731(c) applies, then it doesn't matter what a unit holder does after the distribution, they received a distribution equivalent to cash and that has basis, it can't be "recombined". But again, I sympathize with them, this is uncharted territory. The problem for such unit holders will be what position the company takes on their K-1's? Well, f 'em, they're idiots anyway for not exercising, like I said, no sympathy, even though I killed on over-subscriptions due to their negligence. Thieves probably have little pity for their victims either. Weakness is contemptible.

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