Restructures of financially distressed firms often involve debt-equity exchanges. The concept is straightforward: the company issues equity to its lenders in exchange for their cancellation of some of the company’s debt. The company’s debt burden and interest payment expenses are reduced and its balance sheet is strengthened.

On the downside, the company’s equity holders are diluted, often substantially. The alternative to the restructure, of course, may be a chapter 7 bankruptcy in which the equity owners are wiped out. Lenders don’t usually want to take equity in their debtors, but depending on its security position, a lender may view a debt-equity exchange as a preferable alternative to liquidation or as a necessary component of a chapter 11 case. The exchange will provide the lender with upside on the equity it receives, assuming the company survives and ultimately prospers.

The details of a debt-equity exchange are complex. Multiple classes of debt and equity may be involved. The company and the debtors will need to agree on valuations of different classes of debt and equity, on how much debt and how much equity to exchange, and on the classes and amounts of equity to be exchanged. And as with any major corporate transaction, the tax consequences have to be considered.

If the amount of debt that is cancelled exceeds the fair value of the equity issued in exchange for the debt, the company will recognize cancellation of debt (COD) income in the amount of the excess. I.R.C. § 61(a)(12), § 108(e)(8). If the debtor is an LLC, the equity may consist of either a capital or a profits interest in the LLC.

The Code provides several exceptions to recognition of COD income, including an insolvency exception. If the company issuing the equity is insolvent or in a title 11 bankruptcy case immediately before discharge of its debt, it will not recognize COD income. I.R.C. § 108(a). The tax obligation is deferred and not completely eliminated, because what would otherwise be COD income is applied to reduce several of the company’s tax attributes, beginning with its net operating loss carryovers. I.R.C. § 108(b).

The tax rules on debt-equity exchanges apply to corporations and to LLCs in the same way, with one significant exception. LLCs are taxed as partnerships and LLC income is passed through to the members. COD income of an insolvent LLC will therefore be allocated to the members, but they cannot use the § 108 insolvency exception based solely on the LLC’s insolvency. The members have the income, but the LLC has the insolvency. Not unless the member itself is insolvent can it claim the insolvency exception.

In many cases the member will not be insolvent, in which case the LLC’s COD income will be included in the member’s income unless any of several other exceptions apply to that member. And if the LLC is insolvent, there won’t be any cash distributions to the members to cover their tax bill from the COD income.

LLC members caught in this situation may be able to defer COD income from a debt-equity exchange, if the exchange occurs before the end of this year. The American Recovery and Reinvestment Act of 2009 added a new Code § 108(i), which allows taxpayers incurring COD income as a result of debt-equity exchanges occurring during 2009 or 2010 to elect to defer that income.

The deferred income will be included in the taxpayer’s income ratably over five years, starting in 2014 and ending in 2018. The deferral election is made by attaching a statement to the taxpayer’s return for the taxable year in which the debt-equity exchange takes place. The deferral is accelerated into any year in which the taxpayer’s death, sale of the LLC interest, or cessation of doing business occurs.

The deferral will be attractive for most LLC members receiving COD income. Whether it’s the right choice will depend on the taxpayer’s individual situation, and on what happens to income tax rates during 2014 through 2018.

But the clock is running down on this deferral opportunity. If an LLC restructures with a debt-equity exchange that closes after December 31, 2010, its members will no longer be able to elect the deferral. As the end of 2010 approaches, LLCs contemplating debt-equity exchanges should consider timing the transaction to ensure closing before the year end, in order to preserve the members’ ability to elect the deferral.