Article

Dealing with the tax consequences of debt restructuring or cancellation

2023 year-end tax letter

Oct. 30, 2023 · Authored by Mike Schiavo, Michelle Hobbs

Introduction

Running a business these days is not for the faint of heart. High interest rates, mixed signals on inflation, global and domestic political tensions, extreme weather events, and ever-present worries about a recession all make for a challenging economic environment. On top of all that, hybrid and remote work, while a great benefit for employees, is contributing to empty offices, quiet downtowns and possible trouble on the horizon for the commercial real estate market. Up against these headwinds and crosscurrents, businesses may be struggling to service their debt and may be forced to reckon with the tax consequences of debt restructuring or cancellation.

Cancellation of debt (COD) income can arise in a wide range of situations – even if a debt is not reduced or cancelled outright. For example, foreclosures, significant modifications of the terms of the debt, shareholder contributions of debt to a corporation in exchange for capital, satisfaction of debt with stock or a partnership interest, and acquisition of debt by a related party may all result in taxable income to the borrower. And if that is not bad enough, COD income is “phantom” income – i.e., taxable income without the corresponding cash flow.

Fortunately, there are options available to defer the immediate pain of COD income. This usually takes the form of tax attribute reduction, such as reducing loss carryforwards or reducing the basis of other assets. Depending on how the business is structured, this may take place at the entity level or the individual owner level. While this does not eliminate the problem, deferring the COD income to later tax years buys taxpayers more time to plan for the impact on the business’s cash flow.

COD income – When do you have it?

Foreclosures

When a lender forecloses on a property, if the debt is recourse, the tax impact may be bifurcated into COD income and/or gain or loss. Depending on the balance of outstanding debt, and the fair market value (FMV) and adjusted tax basis of the property, taxpayers could end up with both COD income (which they might be able to defer under the provisions discussed below) and gain or loss (which must be recognized in the year of the transaction).

If the debt is nonrecourse, a foreclosure is treated as sale of the property for federal tax purposes. While there is no COD income in this scenario, the borrower will recognize gain or loss on the transaction in the year of the foreclosure.

Significant modifications of debt instruments

A significant modification of a debt instrument is treated as an exchange for tax purposes. The old debt is deemed to be satisfied with an amount of money equal to the issue price of the new debt. If the issue price of the new debt is greater than or equal to the outstanding balance of the old debt, there is no COD income. On the other hand, if the issue price of the new debt is less than the outstanding balance of the old debt, the taxpayer will realize COD income in the year of the deemed exchange.

In general, a significant modification is any alteration of the legal rights or obligations of the parties that is “economically significant.” All the facts and circumstances are considered collectively to determine whether the modifications to a debt instrument are economically significant.

In addition to this general rule, the tax regulations contain a number of specific rules that must be examined to determine if there is a significant modification. For example:

• A change in yield is a significant modification if the annual yield of the new debt varies by 25 basis points, or 5% of the yield of the unmodified debt.
• A change in the timing of payments that results in a material deferral of the scheduled payments is a significant modification.
• A change in obligor or security, such as the substitution of a new obligor on a recourse debt, or a change in collateral that results in a change in payment expectations, is a significant modification.
• A change in the nature of the debt from recourse to nonrecourse, or vice-versa, is a significant modification.

Loans from partners or shareholders

Partners or shareholders often loan money to struggling businesses rather than making additional capital contributions. From a business standpoint, this may make sense – perhaps not all the owners are willing or able to contribute cash to fund operations, or maybe the lender wants a priority position as a creditor vs. an equity owner. But from a tax perspective, loans from owners are a red flag, and often have unintended tax consequences.

In the partnership context, if the company cannot repay the loan, a common misconception is that the loan can simply be converted to capital without any tax consequences. However, if a partnership satisfies debt by transferring a partnership interest to the lender partner, the partnership will recognize COD income if the FMV of interest is less than the outstanding debt. (The rule is similar for corporations that transfer stock to satisfy a shareholder loan). If the business is in financial difficulty, this is often the result.

If a debtor corporation acquires its debt from a shareholder-creditor as a contribution to capital, the corporation is deemed to satisfy the obligation with an amount of money equal to the shareholder’s basis in the debt. This usually does not trigger COD income. However, if a cash-basis shareholder forgives accrued unpaid interest from an accrual-basis corporation, COD income can arise. In addition, this type of transaction could cause a deemed ownership change and trigger limits on the corporation’s ability to utilize pre-change tax attributes. (This issue is beyond the scope of this article.)

Acquisition of debt by a related party

If the party acquiring the debt is related to the debtor (or acquires debt in anticipation of becoming a related party to the debtor), the debtor will be treated as acquiring its own debt, thereby triggering COD income.

COD income – What can you do about it?

Section 108 of the Internal Revenue Code (IRC) provides taxpayers with several options to exclude COD income from current year taxable income. For example, the bankruptcy exclusion applies if the taxpayer is under the jurisdiction of a court in a Title 11 case, and the debt discharge is granted by the court. Insolvent taxpayers can exclude COD income to the extent that their liabilities exceed the FMV of their assets immediately before the debt discharge. There are also special rules for the real estate industry. COD income attributable to qualified real property business debt (QRPBI) – i.e., debt that was incurred in connection with real property used in a trade or business – can be excluded even if the taxpayer is not in a bankruptcy or insolvency situation.

As noted above, these exclusions are just deferral mechanisms. The tradeoff for the immediate relief from COD income is tax attribute reduction, which means that taxpayers eventually may recognize the income, depending on when various attributes otherwise would have been used. Generally, tax attributes are required to be reduced in a specific order:

• Net operating loss for the current tax year, as well as any NOL carryforwards
• General business credit
• Minimum tax credit
• Capital loss for the current tax year and any capital loss carryforwards
• Basis of property owned by the taxpayer (subject to specific ordering rules). Note that taxpayers can elect to reduce basis of depreciable property first (ahead of NOLs, etc.)
• Passive activity loss and credit carryforwards
• Foreign tax credit carryforwards

Attributes are reduced after the tax liability for the current year is calculated. Generally, attributes are reduced on a dollar-for-dollar basis, except for credits, which are reduced 33 1/3 cents for each dollar excluded.

For C corporations, the bankruptcy and insolvency exclusions are applied at the corporate level, and tax attributes are reduced at the corporate level. There is no direct, immediate impact on the shareholders. S corporations are a hybrid – the bankruptcy, insolvency and QRPBI exclusions are applied at the S corporation level, and tax attributes are reduced at the S corporate level. COD income that is excluded does not pass through to the shareholders and does not increase their basis in their S corporation stock. COD income that is not excluded passes through to the shareholders and increases stock basis, which may free up suspended losses to offset the income. Finally, for partnerships, COD income flows through to the partners, and the exclusions apply at the partner level.

Finally, beyond these specific rules, there may be more complex planning opportunities for COD income, depending on the business’s unique facts and circumstances.

Conclusion

Given the current economic environment, the unfortunate reality is that many businesses may have to face the tax consequences of debt restructuring or cancellation. Recognizing when COD income arises, and what options are available to mitigate it, can be complex. If you are in the process of negotiating with creditors to restructure debt, it is important to work with your Baker Tilly advisor to help you minimize the impact of COD income.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.