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As the economic impact of COVID-19 continues to evolve, many businesses are looking to restructure their debt to help navigate through the crisis. In the past several weeks, lenders have been inundated with such requests, which can have potentially significant federal income tax consequences to both borrowers and lenders. Consequently, tax planning is important when considering debt restructurings, although, in times of economic turmoil, tax considerations sometimes take a backseat to the non-tax decisions that are necessary for a business’s continued viability. Set forth below is an overview of some of the more important tax issues attendant to debt restructurings. We encourage borrowers and lenders to closely examine these issues if they are considering a debt restructuring, and we are here to help advise early on in the process to mitigate unnecessary tax costs.
Debt Modifications and Debt Forgiveness in General
A borrower generally recognizes income when its debt is discharged or satisfied at a discount. This income can take the form of cancelation of debt (“COD”) income, which is generally ordinary in nature, when debt is forgiven or satisfied for an amount less than the outstanding balance. Alternatively, if a lender cancels nonrecourse debt in exchange for a transfer of the collateral securing such debt (essentially a deed in lieu of foreclosure), the borrower generally recognizes gain as if the collateral had been sold for the amount of the debt (regardless of the value of the collateral), and the character of such gain is determined based on the nature and holding period of the collateral surrendered (so called Section 1001 income).1 COD income can also arise without a formal cancellation or reduction of debt. For example, if debt terms are modified in a way that is deemed “significant,” the parties may be treated as having exchanged the original debt instrument for a new debt instrument with the new terms. This deemed exchanged could result in the borrower’s realization of COD income.2
Potential Exceptions to COD Income
There are several exceptions to the COD income rules and a number of related strategies that borrowers can implement to potentially mitigate COD income inclusions. A high-level summary of some of these exceptions and strategies is set forth below. You should note, however, that, while these exceptions and strategies may be effective to avoid the recognition of COD income, they are generally not available to prevent the recognition of Section 1001 income (for example, on a deed in lieu of foreclosure). As a result, the form of the debt discharge can be important. In addition, the availability and effect of these exceptions and strategies can be different for “C” corporation, “S” corporation, and partnership borrowers. We have provided a series of links at the end of this Quick Study that will provide a more detailed explanation of some of the nuances to the application of these items for these varying types of borrowers, as well as a discussion of parallel consequences for lenders holding modified debt instruments.
Taxpayers can generally exclude COD income arising as a result of a debt discharge occurring as part of a Title 11 bankruptcy proceeding. Short of bankruptcy, taxpayers who are insolvent (that is, liabilities exceed the fair market value of assets) immediately before a debt discharge may also be able to exclude all or a portion of any resulting COD income. Unlike the bankruptcy exclusion, which is more absolute, the amount excluded from income under the insolvency exception cannot exceed the amount of the debtor’s insolvency—that is, COD income may be recognized to the extent the discharge renders the taxpayer solvent.
The exclusion of COD income through the bankruptcy or insolvency exceptions does not come without cost. Such exclusion generally requires the taxpayer to make a corresponding reduction in certain favorable tax attributes, including, in particular, net operating losses and the adjusted basis of property, thus potentially resulting in increased income in later years. Taxpayers may have some degree of control over determining which attributes are so reduced. Where excluded COD income exceeds the sum of the taxpayer’s available tax attributes, the excess can be permanently excluded from income.
Taxpayers can also potentially mitigate a COD income inclusion via the conversion by the lender of the debt to equity of the borrower. Different exclusions and strategies may be available depending on whether the creditor is or is not an existing equity holder of the taxpayer.
We encourage you to consult the addendums linked at the end of this Quick Study for more information as to the effect of these exclusions and strategies (and the potential for additional approaches) for your particular form of entity.
The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) (Public Law No. 116-36) included some smaller scale changes related to the above that are potentially of note for borrowers. First, the CARES Act provides a new COD income exclusion exception for borrowers who receive “covered loans” (i.e., certain payroll protection program loans) that are ultimately forgiven. Second, to the extent that the federal Government acquires equity in a corporate taxpayer in satisfaction of a loan that was made or guaranteed by the Treasury Department pursuant to the CARES Act, the issuance of such equity should not result in an “ownership change” for purposes of certain tax attribution limitation rules (i.e., the limitation rules of Internal Revenue Code Section 382) that are generally triggered by “ownership changes.” For a summary of the key business tax provisions of the CARES Act, please see our Quick Study CARES ACT Guide: Overview of Key Business Tax Provisions.
The above discussion could also be significantly impacted by future legislation that Congress enacts to stimulate the economy and help distressed taxpayers. For example, in response to the 2007-2008 financial crisis, Congress added Internal Revenue Code Section 108(i) and allowed taxpayers to defer the recognition of COD income over a five-year period. Congress could similarly enact provisions to help taxpayers deal with COD income attributable to the economic impacts of COVID-19. We will continue to closely monitor this issue and will provide future updates as necessary.
Please click on the below links for a more detailed discussion of these provisions for debtors that are “C” corporations, “S” corporations, and partnerships, as well as a discussion of parallel consequences for lenders holding modified debt instruments.
Visit our COVID-19 Resource Center often for up-to-date information to help you stay informed of the legal issues related to COVID-19.
1. If there is a surrender of property in connection with the cancellation of a recourse loan, a sort of hybrid approach would generally be applied treating the borrower as having sold the property for its fair market value (thus potentially generating Section 1001 income), and as recognizing COD income equal to the excess of the debt amount over such value.
2. In addition, a change in debt terms could result in the new debt instrument being issued with “original issue discount” (“OID”). It is important for borrowers and lenders to consider the potential for OID as the presence of OID could in some cases disallow interest deductions and impact the tax treatment of payments to lenders. An overview of the OID rules is beyond the scope of this Quick Study.