In the current economic environment, financially distressed businesses will seek to renegotiate debt. Cancellation of debt (“COD”) generally results in taxable income, although special rules may apply to avoid or defer income in certain situations. For example, no taxable income is currently recognized where COD occurs as part of a bankruptcy proceeding or where a debtor is insolvent. However, in a non-bankruptcy, noninsolvency context, debtors and creditors are often surprised that a debt modification that does not appear to reduce principal or the effective interest rate may nevertheless result in adverse tax consequences. This article focuses on the debtor. An article in our next issue will consider the creditor’s perspective.
Cancellation of Debt— General Principles
Exemptions from recognition of COD income may also exist in circumstances other than bankruptcy or insolvency.When COD income is excluded from taxable income, the result may be a deferral rather than permanent exclusion of income, or the cost of exclusion may take the form of an adjustment to certain “tax attributes,” for example, a reduction of net operating loss carryovers.
Tax planning for COD transactions is important, particularly for debtors that are S corporations, partnerships or limited liability companies (“LLCs”) that “pass through” income to their equity owners. For example, the insolvency exceptions to COD income apply at the partner or member level in the case of a partnership or an LLC taxed as a partnership. Consequently, the insolvency of a partnership or an LLC will not insulate partners or members from having to recognize COD income. Also, although most COD rules are applied at the corporation level in the case of an S corporation, there are options available to an S corporation facing COD income that can have very different consequences for shareholders.
Detailed tax planning in bankruptcy and insolvency settings requires separate analysis. However, the purpose of this article is to alert the reader to debt modification transactions that may have unexpected tax consequences for a solvent debtor outside of bankruptcy.
A reduction of principal owed by a debtor may be an obvious source of COD income but will not always result in immediate recognition of taxable income. For example, if debt was incurred in connection with an installment purchase of property, the debt modification may be recharacterized as an adjustment to the purchase price of the property. Or if debt of a taxpayer other than a C corporation is “qualified real property business indebtedness,” immediate recognition of COD income may be avoided by adjusting the basis of depreciable property, thereby deferring income recognition.
Debt renegotiation may result not in a reduction of stated principal, but rather in changes to interest, guarantees or other modifications. Unfortunately, for federal income tax purposes, most modifications to debt other than de minimus changes constitute a sale or exchange of an “old” obligation for a “new” obligation and a deemed reduction of principal. Also, because “interest” for income tax purposes generally includes only stated interest that is payable on an unconditional basis not less frequently than annually, interest payments that are subject to cash flow contingencies or that are payable on a deferred basis may be transformed for tax purposes into payments of something other than deductible “interest.” Consequently, if an existing debt is modified, the debtor may be treated as having engaged in a sale or exchange in which the debtor is viewed as having a lesser obligation under the “new” debt than under the original debt. This would generate COD income, even in situations where it appears that the principal amount owed has not been reduced.
Other workout events may also have adverse tax consequences. For example, where a creditor acquires an equity position in a business in exchange for outstanding debt, the debtor will be viewed as retiring the debt for the fair market value of the equity interest given in exchange, thus resulting in constructive debt reduction and COD income unless an applicable exemption to the general rule applies. Or affiliates of a debtor may purchase distressed debt of the debtor at a discount, but COD income is recognized by the debtor when a person “related” to the debtor acquires debt at a discount.
Debt modification sometimes results in the creation of a “new” debt that has original issue discount (“OID”), particularly when the modified debt provides for contingent payments of interest or principal. Thus, even when it appears that principal has not been reduced, the deemed exchange of “old” debt for “new” debt can result in a deemed reduction of principal and a new debt that bears both stated interest and OID. A debtor using the cash method of accounting may be able to claim deductions for periodic amortization of OID payable under the revised debt prior to the time that interest is effectively paid as part of principal. However, such deductions may come at a cost of having to recognize some COD income upon issuance of “new” debt.
The foregoing briefly considers certain tax aspects of debt modification. There are myriad exceptions to the general rules that apply to certain transactions, types of debt and taxpayers having special status. Many of the tax rules applicable to debt modification were developed when credit markets and economic conditions were different, and existing tax rules have uncertain consequences as applied to today’s repackaged and reassigned instruments. New laws or administrative authority may modify rules to address current economic conditions and alter undesirable tax consequences that do not further current tax policies. For example, the IRS recently issued administration guidance that will help protect against loss of net operating loss carryovers for Fannie May, Freddie Mac, AIG and other companies experiencing certain ownership changes attributable to government intervention or to the issuance of new stock in exchange for capital contributions.
Business and economic considerations will be paramount in negotiations to restructure debt, but economic considerations include the tax impact of any restructuring. The tax tail doesn’t wag the dog, but you might not want a dog with an ugly tail.