Tax considerations for distressed companies: Entity structure and cancellation of debt income

COD income and exclusions

Generally, a borrower will recognize ordinary income when debt is discharged for less than its adjusted issue price. Recognition of COD income is generally not required if the borrower’s debt is discharged through a formal bankruptcy proceeding. Similarly, an insolvent borrower is not required to recognize COD income – but only to the extent of the borrower’s insolvency (i.e., the excess of the borrower’s liabilities over the fair market value of its assets, determined immediately before the debt discharge). A borrower availing itself of one of these exclusions is required to make corresponding reductions to certain of its tax attributes (e.g., net operating losses, passive activity losses, and basis).

Critically, the application of such exclusions depends on the borrower’s tax classification. For corporations and entities classified as corporations (including S corporations), bankruptcy and insolvency are tested at the entity level. Thus, if the debt of a corporate borrower is discharged in bankruptcy, the borrower does not recognize COD income. If the corporate borrower is insolvent, it excludes COD income to the extent of its insolvency. Accordingly, the attributes of a corporate borrower’s shareholders are irrelevant to the determination of the amount of COD income required to be recognized by the corporate borrower.

For tax partnerships, however, bankruptcy and insolvency determinations are made at the partner level. This distinction can lead to materially different tax results. A partnership may be economically insolvent, yet each partner may still be taxed on its allocable portion of the partnership’s COD income if such partner is not bankrupt or if it is solvent. Yet a corporate borrower may exclude COD income based solely on its own financial condition without regard to its shareholders.

Partnership incorporation

In general

Because of such disparity, distressed tax partnerships might consider restructuring to be taxed as a corporation in advance of a future debt discharge. Such a restructuring can ring-fence the income tax consequences associated with a complete or partial debt discharge to the corporate borrower where the bankruptcy or insolvency exclusion may be available, notwithstanding the financial condition of its shareholders. However, identifying the income tax consequences associated with such a restructuring requires a facts-and-circumstances analysis and careful planning. Factors to consider include, among others, the following:

• Future prospects of the business
• Identification of the entity that is legally obligated to repay the debt
• Determination of whether a debt discharge is imminent or an eventuality
• Determination of whether the restructuring itself qualifies for nonrecognition tax treatment
• Determination of whether the restructuring will be respected under general tax principles based on the facts and circumstances

S corporation election

S corporations can, in some cases, provide a middle-ground structure. As with C corporations, bankruptcy and insolvency are tested at the S corporation level. S corporation income and loss are passed through to the shareholders, so an S corporation is generally not subject to corporate-level income tax. Accordingly, to the extent the bankruptcy or insolvency exclusion is applicable to exclude all or part of COD income resulting from a debt discharge, such excluded COD income does not pass through to the S corporation’s shareholders or increase each shareholder’s basis in their S corporation stock.

Restructuring tax risks

While restructuring in view of COD concerns can be relatively easy to achieve (e.g., filing Form 8832 to treat an LLC as a corporation), there are important risks to consider. For example, converting a tax partnership into a corporation (whether by state law conversion or entity classification election) can trigger immediate taxable gain to the partners. Generally, transfers (or deemed transfers) of assets to a corporation are treated as tax-free exchanges provided that certain requirements are satisfied. However, if liabilities transferred (or deemed transferred) to a corporation exceed the adjusted tax basis of the assets transferred to the corporation, such excess is treated as taxable “boot” to the transferring shareholder. This risk is often material when restructuring a distressed tax partnership and, in some cases, may offset the restructuring’s intended tax benefits. Timing also matters because transactions undertaken shortly before a debt discharge (particularly if undertaken closely to a discharge and principally to alter tax results) may be subject to IRS challenge under various theories.

Additional technical tax issues may arise when restructuring a distressed partnership. In tax partnerships, COD income is allocated among partners under the partnership agreement. Meanwhile, reductions in partnership liabilities are treated as deemed cash distributions that can trigger taxable gain if such deemed cash distribution to a partner exceeds that partner’s adjusted tax basis in its partnership interest. When a partner is also a lender to the partnership and that loan (recourse to the partner-lender) is fully or partially forgiven, such partner will receive an allocation of the COD income (ordinary income) but may only be able to recognize a capital loss with respect to the bad debt (unless the partner-lender is in the trade or business of lending).

Debt-for-equity exchanges can also generate COD income if the value of the equity issued is less than the amount of the debt being satisfied (for corporations, measured by the fair market value of the equity issued, and for partnerships, which may, if conditions are met, use liquidation value under an IRS safe harbor). S corporations must take care to avoid violating eligibility rules, such as the single-class-of-stock requirement, which can be inadvertently triggered during a debt workout.

Conclusion

The tax consequences of a workout are highly sensitive to both structure and timing. While changes in an entity’s tax classification can potentially mitigate COD-related tax exposure, such changes should be evaluated early and based on available facts and circumstances, determining the likelihood of a future debt discharge, and carefully structured to avoid unintended tax results.