The discussion in this Supplement outlines select federal income tax issues lenders may face in debt restructurings and modifications.2
Taxable Deemed Exchanges
When an amendment or modification is deemed “significant,” the borrower is generally treated as satisfying the original (or old) debt for an amount of money equal to the “issue price” of the new (or amended) debt. Assuming neither the old debt nor the new debt is “traded” and the new debt does not have OID, the issue price generally equals the principal amount of the new debt.3 Consequently, the lender in such a deemed exchange generally realizes taxable income (or loss) on the exchange equal to the excess (shortfall) of such amount realized over (under) such lender’s adjusted tax basis in the old debt. If the lender already recovered all or part of such tax basis through bad debt or worthless security deductions or the lender acquired the debt at a discount, the lender will have taxable gain potential from the exchange (i.e., effectively a recapture of the prior deduction or discount).4 In addition, a portion of the borrower’s deemed payment could be treated as allocable first to accrued but unpaid or untaxed interest amounts and treated as interest payments under various tax rules (collectively, the “Interest First Rules”). As a result, lenders need to exercise some caution around debt amendments and modifications.
Corporate Borrowers and Tax-Deferred Deemed Exchanges
In instances where the borrower is a corporation, a deemed exchange of debt instruments (assuming the debt instruments are “securities”5) can constitute a tax-free (or tax-deferred) recapitalization of the corporate-borrower under the corporate reorganization rules. If the exchange is tax-deferred under these rules, a lender generally does not recognize taxable gain or loss from the exchange so long as the “principal” amounts of the securities deemed exchanged are the same.6 In addition, the lender’s tax basis in the old debt generally becomes its tax basis in the new debt and the holding period of the old debt generally is included in the holding period of the new debt. The potential applicability of these tax-free reorganization rules should be considered whenever a corporate-borrower is involved.
Debt for Equity
As discussed in the separate borrower-specific Supplements, COD income may be excluded from income in an actual exchange of the debt for equity in the borrower. If the borrower is a corporation, the actual exchange for equity in the borrower may be a tax-deferred recapitalization (see above) or a tax-deferred contribution. If the borrower is a partnership, in most instances, the contribution in exchange for equity in the borrower is eligible for tax-deferred treatment under the partnership contribution rules. To the extent that the exchange does not qualify as a tax-deferred recapitalization or tax-deferred contribution, the lender could recognize gain (or loss) on the exchange equal to the excess (shortfall) of such amount realized over (under) such lender’s adjusted tax basis in the contributed debt. However, whether the contribution is to a corporation or partnership, the lender will still need to consider the Interest First Rules and whether amounts are allocated to the payment of accrued yet untaxed interest income.
If a lender is already a partner (or related to a partner) in a borrower-partnership, then the discharge of the borrower-partnership debt will often result in a disproportionate allocation of the resulting COD income to the lender (or the related partner), rather than to all partners, due to the recourse nature of the debt to such partner under the tax partnership rules. When this occurs, the lender (or the related partner) would be allocated COD income (or other similar items) that are generally ordinary in nature; however, the lender may be able to take only a capital loss on the discharged loan in an actual discharge scenario that results in less than full value being paid to the lender. Unless the lender is able to take the position that it is in the business of lending,7 this can create a tax-rate mismatch in certain instances or the inability to offset a capital loss against an ordinary income amount.
Contractually Agreeing on Treatment
Given the multitude of income tax issues relating to debt modifications and restructurings, lenders and borrowers may want to contractually agree on how a particular restructuring or modification will be treated and reported by each other for income tax purposes. In a debt modification or amendment context, a lender may ask a borrower to contractually agree to the tax treatment (e.g., whether the modification or amendment is a “significant” modification resulting in a deemed exchange) in the actual loan amendment documents. Because a lender may have an obligation to file certain information returns with the Internal Revenue Service if a debt modification or restructuring results in COD income, it is generally desirable for a lender and borrower to agree on the resulting tax treatment.
Given the various income tax issues a lender may have as a result of a debt restructuring, modification or discharge, a prudent lender would consult tax advisors before agreeing to undertake any such restructuring, modification or discharge. 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: “C” Corporation Considerations, “S” Corporation Considerations, and Partnership Considerations.
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1. An accrual-method lender generally is required to accrue an interest payment into taxable income on its scheduled payment date (i.e., when the payment becomes unconditionally payable or “fixed” for income tax purposes). However, in a distressed debt circumstance involving a borrower that is not making scheduled interests payments, an accrual-method lender may take the position that interest payments do not accrue into income when there is a reasonable expectation that the interest will not be paid.
2. This Supplement is not intended to be a comprehensive or complete discussion of all tax issues a lender may face in a debt restructuring or modification scenario, and is intended only to provide a high-level summary of certain federal income tax issues. Unless otherwise expressly noted in this discussion, the assumption is that the lender is the original holder of the debt, the debt has no OID, and the relevant debt is not traded (publicly or otherwise), hedged or part of a straddle position, among other things
3. In the case of traded debt, this issue price will be based on the value of such debt. The value of “traded” debt generally equals the fair market (traded) value of the debt at the time of the exchange.
4. Lenders having taxable gain from a deemed exchange will need to determine whether that gain is eligible for installment sale reporting and the character of the gain. In some instances, a lender having taxable income stemming from prior bad debt deductions may be able to take an additional bad debt charge-off with respect to the “new” debt in the year of the deemed exchange to net against all or a portion of such resulting income. The availability and amount of this charge-off will depend on various factors.
5. The applicable tax-free corporate reorganization rules generally apply to exchanges of “securities.” There are a number of factors that go into the determination of whether the debt instruments can be considered securities for this purpose. One of the more important factors relates to the term of the debt instrument—generally, debt with a term of less than five years is considered too short for such debt to be a security and debt with a term greater than five years is considered a security.
6. If the principal amount of the new debt exceeds the principal amount of the old debt, such excess generally is “boot” taxable to the lender under the corporate reorganization rules. Also, under the Interest First Rules noted above, a lender could have interest income to the extent of any value deemed received in exchange for interest amounts.
7. Depending on the specific factual circumstances of the lender, a lender may not be able to or want to take such a position.
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