Debt Discharge in Corporate Recapitalizations: Avoiding Surprises

By Michael S. Kerekes, J.D., Los Angeles, CA

Editor: Lorin D. Luchs, CPA, J.D., LL.M.

Recapitalizations in which corporate debt is restructured or discharged are assuming a new prominence in the current economy. This item addresses some points that may be of particular practical importance in such transactions. Many recapitalizations are tax deferred under Sec. 368(a)(1)(E) (E reorganizations). However, other Code provisions create many exceptions to that nonrecognition treatment, and those exceptions can lead to unpleasant surprises.

A recapitalization generally is a transaction whereby a corporation changes its debt or equity capital structure (or both). Recapitalizations can include stock-for-stock, stock-for-debt, and debt-for-debt transactions. This item discusses transactions in which the debtor corporation is released from debt.

Preliminary Considerations

Some transactions that appear at first glance to be debt-for-debt exchanges may not be recognition events at all. If a change in debt terms is not a “significant modification” as defined by Regs. Sec. 1.1001-3, there may be no exchange.

Another point to consider before beginning to analyze a transaction is whether the debt in question has previously been discharged—for example, by becoming owned by a person related to the debtor and therefore discharged under Sec. 108(e)(4). The consequences of any prior discharge may have a significant effect on the consequences of the recapitalization.

An obligation labeled debt may not actually be debt, and when there is no debt there can be no discharge. If there was serious doubt about an issuer’s capacity to repay at the time of issuance, the obligation may have been equity from the beginning (although if it has been consistently treated as debt this argument may be difficult to sustain). While relatively rare, there may even be instances in which obligations that began as true debt have been converted to equity.

Tax-Free Recapitalizations

Secs. 368(a)(1)(E), 354, and 1032 provide for nonrecognition treatment for the debt holders and the debtor corporation. This provision is broad; a recapitalization that has a business purpose and is carried out under a reorganization plan generally qualifies (Regs. Secs. 1.368-1(c) and 1.368-2(g)). Unlike most reorganizations, there is neither a continuity of interest nor a continuity of business enterprise requirement in a recapitalization. (See Rev. Ruls. 77-415 and 82-34; TD 9182.)

Only debts constituting “securities” are covered by Sec. 354(a)(1). What is a security depends on the facts and circumstances, but obligations with terms of less than 5 years usually are not and those with terms of more than 10 years usually are securities. (See Rev. Ruls. 2004-78 and 59-98; Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders ¶12.41[3] (Warren Gorham & Lamont,  2002).)

Nonrecognition may be available through other transactions such as bankruptcy reorganizations under Sec. 368(a)(1)(G) or contributions to capital. Transaction form may be governed by legal as well as tax considerations.

Exceptions to Nonrecognition Treatment Affecting the Recapitalized Corporation

Normally, even in an E reorganization, income from debt discharge is taxable. (See, e.g., Rev. Rul. 58-546.) However, several exceptions and exclusions mitigate the effects of that rule.

The most critical exception applies when a debtor corporation issues new debt to satisfy old debt. It is treated as having paid the old debt with an amount of money equal to the issue price of the new debt (Sec. 108(e)(10)). In most cases, then, a simple refinancing does not create income. However, the issue price must be determined taking into account any applicable original issue discount. Also, depending on the debtor’s condition, it may be unwise to assume without analysis that the new obligation being issued is debt rather than equity.

If the new obligation is equity, it is covered by Sec. 108(e)(8), which provides that when a debtor corporation transfers stock to a creditor in satisfaction of its indebtedness it will be treated as having satisfied the debt for an amount of money equal to the fair market value (FMV) of the stock issued. A different rule applies if a corporation receives its indebtedness from an existing shareholder as a “contribution to capital” (that is, for no consideration and generally in consideration of the contributor’s shareholder status rather than some other consideration). In that case it is treated as having satisfied its debt for an amount of money equal to the contributing shareholder’s basis in the debt (Sec. 108(e)(6)). It is generally difficult to manipulate application of the two rules by transferring debt to an existing shareholder because of Sec. 108(e)(4), under which debt is deemed discharged when acquired by a person related to the borrower.

Of several exclusions under Sec. 108(a), the one most frequently relevant to a recapitalized corporation is the exclusion applying to the extent the taxpayer is insolvent. (See Secs. 108(a)(1)(B) and (a)(3).) When the insolvency rule applies, debt discharge income is not recognized, but the taxpayer must reduce tax attributes, such as losses, loss carryovers, and basis in assets, to the extent of the exclusion. (See Sec. 108(b).)

Exceptions to Nonrecognition Treatment Affecting Security Holders

The nonrecognition rules do not apply, and the holder is therefore required to recognize income, to the extent that the principal amount of the new debt exceeds the principal amount of the old debt (Sec. 354(a)(2)(A)). The FMV of the new debt is irrelevant. This rule applies only to debt-for-debt exchanges, so if the new security being received is stock with no “principal amount” it does not apply.

Income recognition is also required when the new debt or stock is issued in lieu of payment of accrued interest (Sec. 354(a)(2)(B)). While it might be tempting to try to avoid application of Sec. 354(a)(2)(B) by agreeing that none of the new debt or stock is issued with respect to accrued interest, it seems unlikely that such a contrived arrangement would be respected. (See Bittker and Eustice, ¶12.27, n. 410.)

Collateral Issues

Recapitalizations can change equity ownership and thus bring into consideration loss and credit limitations under Secs. 382 and 383. This can reduce the value of any such tax attributes (but this effect may eliminate objections to allowing them to be reduced or eliminated under the insolvency exception). In many bankruptcy reorganizations, Secs. 382 and 383 will not apply. (See Secs. 382(l)(5) and 383(a)(1).) Thus, where substantial tax attributes are present, a formal bankruptcy proceeding may be desirable.

A recapitalization that changes stock ownership percentages can result in a corporation’s leaving a consolidated group. This may affect both the recapitalization itself (current recognition of excess loss account, etc.) and ongoing planning (loss of opportunity to offset members’ income and losses).

Ordinarily, an exchange of old debt for new debt or stock may be a realizable event for the holder. Under Sec. 368, however, there is no recognition. If the debt holder would recognize a loss absent application of Secs. 368 and 354, this may create a direct conflict of interest between the corporation (which would prefer nonrecognition) and the other parties that wish to recognize losses. To be respected, each part of any arrangement designed to mitigate that conflict must be economically real and based on arm’s-length terms.

Reporting Issues

Different parties may be required to prepare different reporting forms for a recapitalization. When more than one person may be required to make reports based on the same transaction, it is strongly advised that the parties agree on what reports will be issued, and what numbers the reports will reflect, during the planning process.


Lorin D. Luchs, Partner, Washington National Tax Office BDO Seidman, LLP, Bethesda, MD.

Unless otherwise indicated, contributors are members of or associated with BDO Seidman, LLP.

If you would like additional information about these items, contact Mr. Luchs at (301) 634-0250 or

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