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I. Goals of Tax Planning.
The two goals of tax planning in a debt restructuring are to minimize recognition of income from cancellation of indebtedness ("COD income") and to maximize the use of tax attributes, such as net operating losses ("NOLs") and basis, after the restructuring.
II. Cancellation of Indebtedness.
A. What is a debt?
As a general rule, a debtor will recognize COD income if a debt is canceled or discharged.1 In order to recognize COD income, the taxpayer must have a true "debt" that is discharged. Debt is defined as any debt for which the taxpayer is liable or subject to which the taxpayer holds property.2 The following debts may be canceled without creating COD income:
- Contingent Debts.3
- Disputed Debts.4
- Guarantees.5
- Abusive Nonrecourse Debts.
B. What is a discharge?
A cancellation occurs when, based upon an identifiable event, it is clear that the debt will not be repaid.6 Thus, a debt need not be actually canceled or retired to produce COD income. For example, a debtor may realize COD income when a person or entity related to the debtor acquires the debt at a discount from a person unrelated to the debtor.7
Further, even if a debt is canceled, the transaction may not produce COD income if the transaction may be characterized differently because of the relationship of the parties.
(a) Gift - If the parties are related, the transaction may constitute a gift instead of a loan.8
(b) Compensation - If an employer cancels his employee's debt, the transaction could be recharacterized as compensation. 9 The employer would be responsible for employment taxes and withholding on the amount canceled. The transaction would be viewed as if the employer paid compensation to the employee and then the employee used the compensation to repay the loan.
(c) Dividend - Cancellation of a debt owed by a shareholder to its corporation may be treated as a dividend or distribution followed by repayment of the debt by the shareholder.10
(d) Contribution to Capital - Cancellation of a debt owed by a corporation to its shareholder may be treated as a contribution to capital by the shareholder followed by repayment of the debt by the corporation. The shareholder is treated as contributing to the corporation an amount of money equal to his basis in the indebtedness. Thus, if basis is less than the face amount, the corporation could still recognize COD income.11
(e) Partnership Distribution/Contribution - Cancellation of a debt owed by a partner to its partnership may be treated as a distribution followed by repayment of the debt by the partner.12 Also, a discharge of a debt owed by the partnership to the partner should be viewed as a contribution to capital under Section 721.
C. Material Modification or Exchange of Debt.
COD income may be recognized even if the debt is not actually canceled. A change in the terms of a debt instrument can trigger COD income to the debtor or creditor. This result may occur if the debt is either replaced by new debt or the terms of the debt are materially modified.
1. Replacement of Existing Debt.
(a) Debtor Issues.
If a debtor replaces an existing debt with new debt, the debtor will be treated as having satisfied the old indebtedness with an amount of money equal to the issue price (determined under Section 1273 and 1274) of the new debt.13 Therefore, if the issue price of the new debt is less than the adjusted issue price of the old debt, the debtor will realize COD income. The new debt instrument may also contain original issue discount ("OID") that would provide the debtor with interest deductions, however, the deductions will be spread over the term of the debt instrument. Because of the time value of money, the deductions will not fully offset any recognized COD income.
(b) Creditor Issues.
The debt exchange may also cause a creditor to recognize gain if the creditor has taken a worthless debt deduction or purchased the debt at a discount from a previous holder. If the creditor recognizes income ("phantom income") on the exchange, the creditor may argue one of the following positions:
a. The open transaction doctrine applies;
b. The gain should be reported on the installment method; or
c. The doubt as to collectibility doctrine applies.
Each of these theories permits an accrual method taxpayer to report a gain at a later date than normally required under the accrual method of accounting. If any of these theories applies, the creditor will report the gain when he or she actually receives cash from the debtor.
(c) Contingent Consideration.
Additionally, the use of contingent consideration in a debt restructuring may result in recognition of COD income by the debtor or phantom gain by the creditor.
In June 1996, the Internal Revenue Service issued final Treasury Regulations regarding contingent payment debt instru ments.14 The final Regulations became effective on August 13, 1996, The regulations will have a significant impact on future debt restruc turings in bankruptcy. Particularly, the final Regulations inhibit the ability of a debtor in a single asset partnership bankruptcy to give the lender an equity participation in the property in lieu of interest.
Frequently, in a single asset debt restructuring, the lender's indebtedness will be split into two new debts, one debt representing the secured portion of the original loan and the second debt repre senting the undersecured portion. The lender's secured portion will receive interest at a market rate while the under secured portion will receive no interest. Once the property is sold (usually many years in the future), the lender receives a portion of the sales price in addition to the principal of the undersecured loan.
The problem may be illustrated as follows:
Example: ABCD, a limited partnership, owes Lender $6 million that is secured by a building. The fair market value of the building is $4 million. As part of a bankruptcy plan of reorganization, Lender agrees to accept two new loans. Note 1 has a principal amount of $4 million and an interest rate of 9%. Note 2 has a principal amount of $2 million and contains no interest. The loans mature in 10 years or when the property is sold or refinanced. If the property is sold or refinanced, Note 2 is to receive the first $1 million in proceeds.
Under the final Regulations, ABCD would recognize significant COD income as a result of the debt restructuring. In the above example, Lender's debt is replaced with two new debts under the plan. Under the OID Rules, the issue price of Note 1 will be its face amount. Section 1273(b)(4) states that the issue price of a debt instrument that is issued for non-publicly traded property (such as a debt instrument) is the "stated redemption price at maturity". To the extent that the debt instrument has "adequate stated interest" (interest in excess of the AFR), the issue price under Section 1273(b)(4) will be the debt instrument's face amount. Thus, Note 1 does not contain OID, will not cause any COD income to be recognized and will be treated as satisfying $4 million of Lender's $6 million debt.
Lender will also receive in satisfaction of its remaining outstanding debt Note 2 with a $2 million face amount and a participating interest of $1 million that will be paid when the property is sold. Thus, it is expected that Note 2 will be fully paid plus interest (the $1 million participation right) upon the property's sale.
Because Note 2 does not contain any stated interest and contains a contingent payment, under the final Regulations, the contingent payment to the Lender (the $1 million participation right) would be completely disregarded and only the discounted present value of the non-contingent payments under Note 2 (i.e., the present value of $2 million discounted at the AFR over a 10 year period) would be included as the issue price of Note 2.15 Thus, the issue price of the $2 million note would be $1,016,700 (assuming an AFR of 7%). In consequence, Note 2 would generate $983,300 of COD income. Lender's $2 million debt would be treated as being satisfied by $1,016,700. The partners of ABCD would have to recognize the $983,300 of COD income unless they were in bankruptcy or insolvent.16
2. Modification of Existing Debt.
If the terms of an existing debt are materially modified in kind or extent, the debtor will be treated as having exchanged the original debt for new debt.17 If the debt modification is treated as a deemed exchange, COD income may be recognized pursuant to Section 108(e)(10). If the modification is not deemed to be material, there will be no tax consequences to the borrower. The Service recently finalized regulations defining when a modification is material. The final regulations are effective September 24, 1996. The common law debt modification rules are much more flexible than the recently finalized regulations.
(a) When Modification of a Debt is Material.
Treasury Regulations § 1.1001 3 were issued in response to the Supreme Court decision in Cottage Savings Association v. Commissioner.18 The regulations expand the scope of circumstances under which COD income may be triggered in a negotiated workout. Under Treasury Regulations § 1.1001 3, any "significant modification" in the terms of a debt instrument will be considered an exchange. A modification of a debt instrument is defined as any alteration in any legal right or obligation of the issuer or holder unless the modification occurs by operation of the original terms of the instrument.19
The final Regulations state that the following modifications are considered "significant":
(a) General Rule. A modification is significant only if, based upon all the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant20;
(b) A change in the yield to maturity of more than 25 basis points or 5% of the annual yield of the unmodified instrument21;
(c) An extension of the final maturity of more than the lesser of five years or 50% of the original term if the extension results in the material deferral of scheduled payments22;
(d) Changes in the obligor, security, or guarantor of recourse debt and in some cases change of collateral securing nonrecourse debt23;
(e) A change in priority of the debt if it results in a change in payment expectation24;
(f) A change from recourse to nonrecourse or vice versa25.
There is language in the final Regulations that may require retesting for debt-equity purposes whenever debt is substantially modified.26 With so much real estate under water this could make lenders partners or owners of real estate when even under-water debt is modified, with disastrous tax consequences to the owners.
D. Stock-for-Debt Exchanges.
After 1994, an exchange of debt for stock is treated as a repayment of the debt in an amount equal to the fair market value of the stock. 27 Prior to 1994, the stock-for-debt exception provided that no COD income was created when a debt was exchanged for stock &emdash; the event was not a realization event for the debtor. The repeal of the stock-for-debt exception has created a greater importance in establishing the value of stock received in bankruptcy.
III. Exceptions.
A. Bankruptcy.
Cancellation of indebtedness of bankrupt taxpayers is excluded from income.28 Bankrupt taxpayers are those under the jurisdiction of the bankruptcy court where the discharge of indebtedness is either granted by the court or pursuant to a plan approved by the court.29
B. Insolvency.
Gross income does not include income from discharge of indebtedness of an insolvent taxpayer.30 The amount excludable from gross income by an insolvent taxpayer is limited to the amount by which the taxpayer is insolvent.31 A taxpayer is considered insolvent if the liabilities of the taxpayer immediately preceding the discharge of the debt exceed the fair market value of the taxpayer's assets.32
Liabilities. In Revenue Ruling 92 53,33 the Service stated that, in determining solvency it will ignore nonrecourse debt in excess of the value of the property securing that debt (except where that excess nonrecourse debt itself is being forgiven). It is unclear as to whether contingent liabilities should be valued and included in liabilities.34
Assets. In determining solvency, exempt assets under state law are not included in the taxpayer's assets.35 Often a taxpayer will hold partnership interests. To value the interests, the taxpayer should evaluate the partnerships assets and liabilities. If there is equity in the partnership interest, then the partner should apply an appropriate marketability discount.
1. Attribute Reduction.
A taxpayer who excludes COD income from gross income due to the bankruptcy or insolvency exception is required to reduce other tax attributes by the amount of the excluded income. This reduction is done in the following order of priority:
(a) net operating losses and net operating loss carryovers;
(b) general business credits under Section 38;
(c) alternative minimum tax credits;
(d) net capital losses and capital loss carryovers;
(e) the basis of depreciable property (to the extent the basis exceeds remaining liabilities);
(f) passive activity losses and credit carryovers; and
(g) foreign tax credits and carryovers.36
The reduction in attributes occurs after the determination of tax for the year of the discharge.37 Attributes are reduced dollar-for-dollar, except for tax credits, which are reduced 33 1/3 cents for each dollar.38 A taxpayer may instead elect to first reduce the basis of depreciable property. The reduction in basis is limited to the taxpayer's adjusted basis of depreciable property held at the beginning of the taxable year following the taxable year in which the debt is discharged.39 (The reduction in basis is not limited to the excess of the basis in depreciable property over remaining liabilities.)40 Reductions in the basis of depreciable property are made in the following order of priority: (i) depre ciable property for which the debt was incurred, (ii) other depreciable property securing the debt, and (iii) all remaining depreciable property.41
C. Cancellation of Partnership Indebtedness.
If a partnership realizes COD income, whether such income must be recognized is determined separately for each partner.42 A bankrupt or insolvent partner would not recognize taxable income currently but would reduce other tax attributes and would have the opportunity to elect to reduce the basis of depreciable property. A partner's interest in depreciable property includes the basis of partnership interests to the extent of the partner's proportionate interest in the partnership depreciable property if there is a corresponding reduction in the partnership's basis in the property with respect to such partner.43
A solvent partner would recognize taxable income unless the exclusion for qualified real property business indebtedness (discussed below), the qualified farm indebtedness exception, or the purchase price adjustment exception applies.
D. Cancellation of S Corporation Indebtedness.
In an S Corporation debt restructuring, the insolvency and bankruptcy exceptions are applied at the corporate level, not the shareholder level.44 Further, corporate attributes, not the attributes of the shareholders, will be reduced under Section 108(b). Because of the pass-through nature of an S corporation, the only attribute the corporation should have to reduce is basis in its property. Additionally, any loss that is suspended under Section 1366(d)(1) is treated as an NOL.45
E. Purchase Price Adjustment.
1. General Rule.
A reduction in seller-provided debt does not result in COD income for a solvent debtor. The reduction in debt is treated as a reduction in purchase price and results in a reduction in the debtor's adjusted basis in the property acquired with the debt.46 The legislative history to Section 108(e)(5) provides that neither the property nor the debt obligation may be transferred.47 Thus, the purchase price adjustment exception only applies between the original purchaser and seller.48 The reduction is not limited to depreciable property. The purchase price adjustment rules are not elective.
2. Partnerships.
Where the debtor is a partnership, the purchase price adjustment is made at the partnership level.49 Where the partnership is bankrupt or insolvent, but the partners are solvent, the Service stated in Revenue Procedure 92 9250 that it would not challenge the partnership's use of the purchase price adjustment provided that all of the partners use consistent income tax reporting.
3. Common Law Purchase Price Adjustment.
The statutory purchase price adjustment rules of Section 108(e)(5) are very narrow because they only apply to seller financing. The legislative history to the Bankruptcy Tax Act of 1980 indicates that Section 108(e)(5) was not to be exclusive and that the old judicial purchase price reduction exception rules continue to apply.51 Thus, the judicial exception may apply to non-seller financing. The cases under the judicial exception require the purchase price to be reduced because of a decline in value of the property.52 Thus, the property should be appraised to establish its value. In Revenue Ruling 92 99,53 the Service stated that it would not follow the judicial purchase price exception rules in cases where non-seller debt was involved.
F. Qualified Real Property Business Indebtedness.
1. General Rule.
The Revenue Reconciliation Act of 1993 added an exception for COD income related to "qualified real property business indebtedness" of taxpayers other than C corporations.54 The new exception applies to discharges of real property business indebtedness occurring after December 31, 1992.55 Taxpayers, other than C corporations, may elect to exclude from gross income a portion of the income derived from the discharge of qualified real property business debt. The election must be made by filing Form 982 with the taxpayer's return for the taxable year in which the discharge occurs.56
The amount of excluded income is treated as a reduction in the basis of the taxpayer's depreciable real property.57 The amount excluded cannot exceed the taxpayer's basis in the depreciable real property and is also limited to the excess of the amount of the principal of the debt over the fair market value of the property securing the debt (reduced by the principal amount of any other qualified real property indebtedness secured by the property).58 The Service is considering whether accrued interest should be included in the principal of the debt.59
2. Definition of Qualified Real Property Business Indebtedness.
"Qualified real property business indebtedness" is debt incurred or assumed in connection with real property used in a trade or business and secured by that property. However, it does not include debt incurred or assumed on or after January 1, 1993, unless that debt is incurred to acquire, construct or substantially improve the real property secured by the debt or is incurred to refinance qualified real property business debt incurred or assumed before that date (but only to the extent the amount of the debt does not exceed the amount being refinanced).60
3. Partnership and S Corporations.
With respect to partnerships and S corporations, the determination of whether the debt is qualified real property indebtedness is made at the entity level. For partnerships the election to exclude income and reduce the basis of property is made by the partner. For S corporations the election is made by the S corporation, not by its shareholders. Partners which are C corporations are not eligible to make the election. If a partner makes the election, basis is reduced in the partner's interest in the partnership to the extent of the partner's proportionate interest in the depreciable real property held by the partnership. The partnership's basis in depreciated real property with respect to such partner is correspondingly treated.61 It appears that a partner may reduce the basis of depreciable real estate held outside the partnership if the partner's share of partnership depreciable basis is insufficient. However, this may give rise to partnership tax problems discussed in Part V below.
4. Basis Reduction.
The required basis reduction generally applies to depreciable real property held by the taxpayer at the beginning of the taxable year following the taxable year in which the debt is discharged.62 If the taxpayer disposes of real property (in the transaction that gave rise to the discharge or otherwise) prior to the first day of the next taxable year, then the reduction in basis of such property is made immediately before the disposition.63 Taxpayers may not make the election available under present law to treat as depreciable real property real estate held primarily for sale to customers.64 When depreciable real property, the basis of which has been reduced, is disposed of, then for purposes of determin ing the amount of ordinary income depreciation recapture under Section 1250 &emdash;(i) the basis reduction is treated as an allowance for depreciation, and (ii) the determina tion of depreciation under the straight line method is made as if there had been no reduction. Accordingly, the amount of ordinary income depreciation recapture is reduced over time as the taxpayer forgoes depreciation deductions.65
IV. Reporting Requirements.
The Revenue Reconciliation Act of 1993 added a provision that requires an "applicable financial institution" to file an information return (Form 1099 C) when it has discharged debt of $600 or more. These rules generally apply to discharges occurring after December 31, 1993, except in the case of certain governmental entities where they apply to discharges after August 10, 1993, the date of the Act.66 An "applicable financial institution" is a bank, savings & loan, credit union, certain governmental entities, or subsidiaries of the above-described entities. The Service issued Regulations § 1.6050P 1 governing the procedures to be followed under the reporting requirements.
****************************************FOOTNOTES**************************** *****************
1 Section 61(a)(12).
2 Section 108(d)(1).
3 See, Sobel v Comm'r, 40 B.T.A. 1263 (1939).
4 See, Zarin v. Comm'r, 916 F.2d 110 (3d Cir 1990).
5 See, Landreth v. Comm'r, 50 T.C. 803 (1968).
6 See, Treas. Reg. § 1.6050P-1(b)(1) and Cozy v. Comm'r, 88 T.C. 435 (1987).
7 Section 108(e)(4).
8 See, Helvering v. American Dental Co., 318 U.S. 322 (1943); Comm'r v. Jacobson, 336 U.S. 28 (1949); Bosse v. Comm'r, 29 T.C.M .1772 (1970), Capital Coal Corp v. Comm'r, 250 F.2d 361 (2d Cir 1957); Reynolds v. Boos, 188 F.2d 322 (8th Cir 1951).
9 See, Treas. Reg. § 1.61-12(a) and Rev. Rul. 69-465, 1969-2 C.B. 27.
10 See, Treas. Reg. §1.301-1(m); Shephard v. Comm'r, 340 F.2d 27 (6th Cir), cert denied, 382 U.S. 813 (1965); Hash v. Comm'r, 273 F.2d 248 (4th Cir 1960).
11 Section 108(e)(6).
12 Treas. Reg. §1.731-1(c)(2).
13 Section 108(e)(10).
14 Treas. Reg. § 1.1275 4.
15 Treas. Reg. § 1.1275 4(c).
16 The solvent partners may elect to exclude the COD income from gross income under the qualified real property business indebtedness exception contained in §108. However, the property's basis would be reduced by the amount of COD income excluded. Thus, the qualified real property business indebtedness exception merely defers the gain recognition, it does not eliminate the income.
17 Treas. Reg. §1.1001 1(a).
18 499 U.S. 554, 111 S.Ct. 1503, (1991).
19 Treas. Reg. §1.1001-3(c).
20 Treas. Reg. §1.1001-3(e)(1).
21 Treas. Reg. §1.1001-3(e)(2).
22 Treas. Reg. §1.1001-3(e)(3).
23 Treas. Reg. §1.1001-3(e)(4)(i-iv).
24 Treas. Reg. §1.1001-3(e)(4)(v).
25 Treas. Reg. §1.1001-3(e)(5)(ii).
26 Treas. Reg. §1.1001-3(e)(5)(i).
27 Section 108(e)(8).
28 Section 108(a)(1)(A).
29 Section 108(d)(2).
30 Section 108(a)(1)(B).
31 Section 108(a)(3).
32 Section 108(d)(3).
33 1992 2 C.B. 48.
34 See, F. Witt & W. Lyons, An Examination of the Tax Consequences of Discharge of Indebtedness Income, 10 Va Tax Rev. No 1 (Summer 1990).
35 See, Hunt v. Comm'r, 57 T.C.M. 919 (1989); PLR 9125010 (March 19, 1991); PLR 9130005 (March 29, 1991); and PLR 8920019 (February 14, 1989).
36 Section 108(b)(2).
37 Section 108(b)(4)(A).
38 Section 108(b)(3).
39 Section 108(b)(5).
40 Section 1017(b)(2).
41 Treas. Reg. §1.1017 1(a).
42 Section 108(d)(6).
43 Section 1017(b)(3)(C).
44 Section 108(d)(7)(A).
45 Section 108(d)(7)(B).
46 Section 108(e)(5).
47 See, S. Rep. No. 1035, 96th Cong., 2d Sess. 16 17 (1980).
48 The Service has not strictly applied the original purchaser/seller rule. In PLR 9037033 (June 18, 1990), the original purchaser of stock transferred both the stock and the debt obligation to a holding company in a Section 351 transaction. The holding company later renegotiated the debt with the original seller. The Service stated that Section 108(e)(5) applied to the transaction.
49 See, PLR 8429001 (March 12, 1984).
50 1992 2 C.B. 505.
51 Senate Report 96 1035, 2d Session. 20, note 24, (1980) (1980 2 C.B. 620, 630).
52 See Sutphin v. United States, 88 1 U.S.T.C. ¶ 9269 (Cl. Ct. 1988); Comm'r v. Sherman, 135 F.2d 68 (6th Cir. 1943); Hirsch v. Comm'r, 115 F.2d 656 (7th Cir. 1940).
53 1992 2 C.B. 35.
54 Section 108(a)(1)(D) and 108(c).
55 As of September 5, 1996, California has not yet enacted contingency legislation to new Section 108(c).
56 Temp. Treas. Reg. § 1.108(c) 1T(b). Announcement 94 11, I.R.B. 1994 4, 14.
57 Section 108(c)(1)(A).
58 Section 108(c)(2).
59 See BNA Daily Tax Report 9 10 93, p G 11.
60 Section 108(c)(3).
61 House Report 103 213, 1st Session, pp. 51 52 (1993).
62 Section 1017(a).
63 Section 1017(b)(3)(F)(iii).
64 Section 1017(b)(3)(F)(ii).
65 House Report 103 213, 1st Session, p. 52 (1993).
66 Section 6050(P).
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Last updated February 2, 1998