Tax Planning for Debt Restructuring: Limiting COD When a Debtor Can Least Afford More Taxes
Corporate & Finance Alert
June 2, 2009
In the current financial climate, many borrowers need to restructure their debt obligations so that interest and principal payments better match their cash flows. While reducing debt service is the primary goal, without careful planning debt restructuring can trigger cancellation of indebtedness income (“COD”). Troubled debtors often lack the cash to pay the income tax on COD. Understanding the basic triggers of COD, and working with several available exceptions can often produce a much better tax result.
1. Nature of COD and Common Triggers
Cancellation of indebtedness generates taxable income under federal income tax law because the initial advance of the loan proceeds did not trigger income. At the time that the loan is released in whole or in part, the taxpayer must recognize income because the release of the obligation to repay the whole or a portion of the indebtedness is an accession to wealth. What makes COD especially difficult for many debtors is that because their business or properties are buried under debt and valuations are down, emotionally and perhaps even economically, they do not feel that they have obtained any accession to wealth.
COD can also be triggered under Section 108(e)(4) of the Internal Revenue Code of 1986, as amended (the “Code”), when a related party to a debtor, typically applying a 50% related party test, acquires the debt from a creditor currently unrelated to the debtor. This provision acts to prevent debtors from arranging for a related party to acquire debt from a commercial creditor at a discount, and “park” the debt with a related party without triggering COD.
2. Definitional Exceptions
Although many troubled debtors have net operating losses to shelter COD, the Code and case law include several definitional exceptions from COD that at times can be helpful in avoiding COD in the first place. A brief description of two of these exceptions follows.
A. Purchase Price Reduction Exception
If the creditor holding the outstanding debt acquired that indebtedness through the creditor’s sale of property to the debtor, and the debtor and creditor negotiate a reduction in the debt when the debtor is not in a Title 11 case, and is not otherwise insolvent, then that reduction of debt is treated as merely a purchase price adjustment that does not trigger COD. Instead, the debtor/buyer is treated as having paid a lesser amount for the property, and the seller/creditor is treated as having sold the property for a lesser amount.
B. Contributions to Capital of Corporations
Code Section 108(e)(6) contains a COD exception when a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital. This exception only applies if the creditor was a shareholder of the corporation, and only to the extent of the shareholders’ adjusted basis in the indebtedness. This exception can be very useful when a major shareholder has made advances to a corporation, and in order to shore up its investment, it agrees to contribute its debt to the corporation. This exception is frequently used at the time when a parent creditor corporation sells the stock of a subsidiary to eliminate intercompany indebtedness and not generate adverse tax consequences to the subsidiary. In effect, the debt is treated as capital rather than indebtedness of the subsidiary.
3. Statutory Exclusions
Code Section 108 includes a number of statutory exclusions from COD that come with a trade-off. Although the taxpayer does not recognize COD, it must reduce its basis in certain assets or tax attributes.
Perhaps one of most frequently used statutory exceptions is found in Code Section 108(a)(1)(B) which provides that gross income does not include an amount that otherwise would constitute COD if the discharge occurs while the debtor is insolvent. For example, if a debtor is indebted to the extent of $5 million, has other unencumbered assets of $2 million, forgiveness of the full $5 million of indebtedness would be excluded under this exception only to the extent of the $3 million of indebtedness in excess of the fair market value of the assets of the debtor.
As illustrated by this example, the Code’s definition of insolvency means the excess of liabilities over the fair market value of assets. Because this is fundamentally a balance sheet test, debtors can look to their financial statements, adjusted to reflect fair market values, to determine whether they are insolvent, rather than a more subjective analysis of the extent to which obligations can be paid in due course.
A separate exclusion exists for when a discharge occurs while the debtor is in a Title 11 case. A Title 11 case is any bankruptcy case, regardless of whether the matter is a Chapter 11 restructuring or a Chapter 7 liquidation. The bankruptcy exclusion is broader than the insolvency exclusion since the bankruptcy exclusion applies even if the debt discharge makes the debtor solvent.
C. Qualified Real Property Business Indebtedness
A further exclusion of special interest to real estate developers is that for qualified real property business indebtedness, which only applies to taxpayers other than C corporations. The term “qualified real property business indebtedness” means indebtedness that (i) was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by the real property, and (ii) with respect to which the taxpayer elects to have the exclusion apply. Importantly, the amount excluded under this exclusion cannot exceed the excess of (i) the outstanding principal amount of the indebtedness, over (ii) the fair market value of the real property.
D. Trade-off for Statutory Exceptions
The trade-off for the Section 108(a) exclusions is that while COD is excluded from gross income, the amount excluded is applied to reduce certain tax attributes of the taxpayer. The tax attributes affected, in their order of reduction, are as follows:
- Net operating losses;
- General business credit;
- Minimum tax credit;
- Capital loss carryovers;
- Basis reduction;
- Passive activity loss and credit carryovers; and
- Foreign tax credit carryovers.
Critically, net operating losses are the first tax attribute to be reduced. Under a special election, taxpayers can elect to apply the reductions first against depreciable property rather than any of the other tax attributes. In some situations, such as when a particular property is not expected to be sold and NOLs can be used against operating income, this can be a useful rule.
Note that the reductions of tax attributes are made after the determination of tax imposed by the Code for the taxable year in which the discharge occurs. This means that it may be possible to utilize net operating losses in the year of the discharge even though a portion or all of those net operating losses will be eliminated as of the start of the following taxable year.
4. Application of Rules to Corporations vs. Partnerships
For corporations, including S corporations, the rules with respect to: (i) the application of the statutory exclusions and the reduction of tax attributes, (ii) the determination of insolvency when applying the insolvency exception, and (iii) the application of the qualified real property business indebtedness exception, are all applied at the corporation level, rather than the shareholder level.
In contrast, with respect to partnerships, or limited liability companies treated as partnerships for federal income tax purposes, these same operating rules are applied at the partner level. Since the insolvency exclusion and the bankruptcy exclusion are applied at the partner level and not at the partnership level, the exclusions are often unavailable for a debtor structured as a partnership because one or more partners are not in bankruptcy and are not insolvent. As a result, planning for the restructuring of debt is often more complex for a partnership than for a C corporation or an S corporation.
5. Difference Between Tax Treatment of Restructurings and Sale Transactions
The foregoing discussion relates to what are commonly called pure debt restructurings. The exceptions and exclusions address the tax consequences to the debtor when it simply restructures indebtedness owed to a third-party creditor and does so without a related transaction with respect to the debtor’s assets or outstanding equity interests. If instead, a creditor and debtor negotiate a restructuring, and the restructuring includes a transfer of an asset or an interest in the debtor to the creditor, different results will likely occur. Thus, in any debt restructuring, it may be wise to consider the tax consequences of a foreclosure, the issuance of a deed in lieu of foreclosure, or a sale to a third party.
The critical tax difference between a pure debt restructuring and a asset or entity interest transfer is that a transaction may generate capital gains rather than COD treated as ordinary income. This difference may not matter to a debtor structured as a C corporation, where there is no differential between the applicable federal income tax rates for capital gains and ordinary income. But for a partnership or an S corporation, a transaction may generate long-term capital gain income to the entity, which then flows through to the individual shareholders or members who may be taxed only at the current 15% long-term capital gain rate. This possibility of converting what might otherwise be COD taxable at a 35% federal rate into long-term capital gains taxable at a 15% rate creates an important planning opportunity.
Tax planning needs to take into account the different treatment for the release of nonrecourse debt from that of recourse debt. The release of nonrecourse debt as part of an asset sale will generate an amount realized with respect to the sale transaction. This will be true for recourse debt only to the extent of the fair market value of the transferred asset. The excess of the recourse debt over the fair market value of the transferred asset will be treated as COD.
The definitional exceptions and statutory exclusions from COD, and the different ways these rules apply depending on whether a debtor is structured as a C corporation, S corporation, or partnership, all mean that debt restructuring can be a fertile area for tax planning. Especially because of the ordinary income nature of COD and the possibility of generating capital gain income through a sale transaction, debtors in the process of restructuring their debt need to retain qualified tax advisors to carefully analyze their situation and see which type of structure might best protect them from a large income tax liability when they can least afford to pay it.