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The discussion in this Quick Study Supplement outlines select federal income tax issues “S” 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.
Bankruptcy and Insolvency Exclusion Impact on Deemed NOLs
As an “S” corporation is a flow-through entity for U.S. federal income tax purposes, COD income does not create tax at the “S” corporation level, but instead such income passes through to and is taxed to the “S” corporation’s shareholders. As is generally the case for income passing through to an “S” corporation’s shareholders, the corporation’s shareholders increase their tax basis in their stock by their share of the amount of the “S” corporation’s recognized COD income. Notwithstanding this pass-through nature of the resulting income, the calculation of COD income as outlined in our overview Quick Study and the application of the bankruptcy and insolvency exceptions highlighted therein are determined at the “S” corporation level rather than the shareholder level.
As generally required for all taxpayers, the exclusion of COD income under the insolvency or bankruptcy exclusion requires that the “S” corporation make a corresponding reduction of certain favorable tax attributes. While an “S” corporation generally will not have net operating losses (“NOLs”) subject to these attribute reduction rules (unless it has a “C” corporation history”), certain deductions and losses flowing through to the shareholders of an “S” corporation are treated as “deemed NOLs” for these purposes and are thus subject to reduction. Very generally, deemed NOLs are losses and deductions allocated to an “S” corporation shareholder that exceed such shareholder’s adjusted tax basis in the “S” corporation (sometimes referred to as “suspended losses”). An “S” corporation may elect instead to first reduce the tax basis of its depreciable property before reducing any such “deemed NOLs.” Such election is made at the “S” corporation level.
Discharge of Debt through Capital Contribution or Stock Issuance
In addition to the bankruptcy and insolvency exclusions, an “S” corporation can often mitigate COD income by converting a lender’s loan into equity of the “S” corporation. If the lender is an existing shareholder, the creditor can contribute the debt to the capital of the 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 principal amount of the debt (i.e., the lender did not acquire the debt at a discount), the “S” 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.
The “S” corporation eligible shareholder rules can also be an important issue here. Such provisions prohibit certain creditors from becoming shareholders of the “S” corporation either because the creditor is an ineligible “S” corporation shareholder (e.g., a “C” corporation or a partnership) or because the creditor would result in the “S” corporation having more than 100 shareholders. An “S” corporation borrower should determine whether a lender is an eligible shareholder before converting such lender’s loan into equity to avoid a potential loss of “S” corporation status.
Increase of Accumulated Adjustments Account by COD Income
Any COD income that is not excluded as discussed above will increase the “S” corporation’s “accumulated adjustments account.” Generally, this is an account the “S” corporation uses to track distributions taxed to its shareholders for the purpose of determining whether future distributions to shareholders are subject to tax because of being treated as made out of its accumulated earnings and profits from a time when it was taxed as a “C” corporation. Each “S” corporation maintains an accumulated adjustments account but it is generally only relevant for “S” corporations with a “C” corporation history.
Given the various income tax issues an “S” corporation borrower may have as a result of a debt restructuring, an “S” 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: “C” 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 an “S” 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 “S” corporation’s stock (because of the attendant shift in value to the other shareholders).