Locke Lord QuickStudy: Federal Income Tax Considerations for Debt Workouts During an Economic Downturn – “C” Corporation Considerations Supplement

The discussion in this QuickStudy Supplement outlines select federal income tax issues “C” corporation borrowers may face in debt restructurings.1 As noted in our debt restructuring overview Quick Study, a borrower generally recognizes income—cancellation of debt (“COD”) income or Section 1001 income—when its debt is discharged or satisfied at a discount. In addition to the bankruptcy and insolvency exclusions discussed in the overview Quick Study, a “C” corporation borrower may be able to mitigate the potential impact of COD income through alternative strategies.

Discharge of Debt through Capital Contribution or Stock Issuance

If the lender is an existing shareholder, the creditor can contribute the debt to the capital of the “C” corporation, with no additional shares being issued, which will be treated as the debt being satisfied with an amount of money equal to the lender’s adjusted tax basis in the debt.2 As long as the lender’s adjusted tax basis in the debt is not less than the outstanding amount of the debt (i.e., the lender did not acquire the debt at a discount), the “C” corporation borrower may avoid COD income with respect to such debt discharge.

Alternatively, a lender could exchange the debt for shares of stock of the corporation—in this alternative situation, the corporation will recognize COD income to the extent that the fair market value of the stock is less than the discharged debt (which can often be the case with a distressed company). Form, including importantly whether any new shares of stock are issued as part of the restructuring, can thus be very important.

Ownership Changes – Net Operating Loss Limitations

The issuance of stock to a lender as contemplated above raises potential collateral issues for “C” corporation borrowers that have certain favorable tax attributes (e.g., net operating losses). Such tax attributes could be limited if there has been a more than fifty percent change in ownership of the corporation (by value) over a three year period. If the “C” corporation has significant tax attributes and is contemplating issuing stock to a lender as a COD income mitigation strategy, it should analyze whether such stock issuance will limit its ability to use its tax attributes going forward. As discussed in our overview Quick Study, the issuance of equity interests to the U.S. Treasury in satisfaction of certain loans that were made or guaranteed by the Treasury Department under the CARES Act should not result in an ownership change for purposes of these attribute limitation rules.

Given the various income tax issues a “C” corporation borrower may have as a result of a debt restructuring, a “C” corporation borrower should consult tax advisors before restructuring its debt. For additional information and context, please contact one of the authors.

Links to the additional more detailed discussions referenced in the overview Quick Study are provided here for your convenience: “S” Corporation Considerations, Partnership Considerations, and Lender Considerations.

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1. This Supplement is not intended to be a comprehensive or complete discussion of all tax issues a “C” corporation borrower may face in a debt restructuring scenario, and is intended only to provide a high-level summary of certain federal income tax issues.
2. Since no new shares are issued as part of such restructuring, this alternative may be of limited utility where the lender does not already own directly or indirectly all or almost all of the “C” corporation’s stock (because of the attendant shift in value to the other shareholders).