The recent economic downturn coupled with the tightening of the credit market has forced many financially distressed corporations to renegotiate the terms of their maturing debt obligations. As little as 12 months ago, these companies would have been able to refinance their maturing debt with slightly higher credit terms or simply would have received an extension on their original agreement.
Unfortunately, today’s creditors are facing the harsh reality that they must demand payment from debtors under the original terms outlined in the credit agreement or face the possibility of receiving none of the principal and interest due at the date of maturity. Many subordinated debt holders have been eager to offer substantial settlements in lieu of extending credit terms or refinancing for fear that the current economic downturn is here to stay. In addition to allowing the creditor to retrieve some of its original investment, this cancellation of debt can be a substantial windfall to a debtor company on the verge of financial collapse.
The Code’s general rule considers cancellation of debt (COD) income under Sec. 61(a)(12). However, Sec. 108 provides some relief to the financially distressed beneficiaries of these debt cancellation offers. The relief provided under Sec. 108 depends on the debtor’s financial viability and the terms of the COD settlement.
Sec. 108(a) excludes from gross income COD income if the discharge occurs in a Title 11 (bankruptcy) case (Sec. 108(a)(1)(A)) or when the taxpayer is insolvent (Sec. 108(a)(1)(B)). It should be noted that under Sec. 108(a)(3), the amount of the exclusion under the insolvency exception of Sec. 108(a)(1)(B) will be limited to the excess of the debtor company’s fair market value (FMV) of its liabilities over the FMV of its total assets.It should also be noted that determining the company’s FMV may be a difficult task. Many credit deals are renegotiated at the brink of financial collapse, and substantiating corporate FMV will likely require the assistance of third-party valuation experts. The use of these experts may require a significant amount of time and financial resources, neither of which the company may have.
In either insolvency or bankruptcy, the amount of COD income excluded will result in a reduction of the company’s tax attributes by the exclusion amount. Once the excluded COD has been determined, the amount excluded shall be applied to reduce the tax attributes of the company in the following order (Sec. 108(b)):
1. Net operating losses (NOLs);
2. General business credits;
3. Minimum tax credits;
4. Capital loss carryovers;
5. Basis of property;
6. Passive activity loss and credit carryovers; and
7. Foreign tax credit carryovers.
Under Regs. Sec. 1.108-7(b), the above tax attributes subject to reduction are taken into account by the taxpayer for the tax year of the discharge before such attributes are reduced. Furthermore, Regs. Sec. 1.108-7(a)(2) states that if the excluded COD income exceeds the sum of the taxpayer’s tax attributes, the excess is permanently excluded from the taxpayer’s gross income. In most cases, the loss of these tax attributes will be a much more attractive option for the debtor company because most financially distressed companies will never fully utilize their accumulated tax attributes.
Instead of reducing tax attributes in the order described in the preceding list, the company may elect to first reduce the tax basis of depreciable assets (Sec. 108(b)(5)). Excluded debt discharge income in excess of the tax basis of depreciable assets is then used to reduce other attributes according to the normal ordering procedure.
Indebtedness Contributed as Capital
Another exception to the general rule that COD be treated as gross income under Sec. 61(a)(12) involves any debt discharge that qualifies as a capital contribution by a shareholder. If a principal shareholder’s cancellation of debt owed to the shareholder by the corporation was forgiven in order to improve the corporation’s financial position, the debtor corporation is treated by Sec. 108(e)(6) as having satisfied the debt with cash equal to the shareholder’s adjusted basis in the debt. The shareholders/creditors involved in this transaction would receive additional basis in their stock of the distressed company.Indebtedness Satisfied by Corporate Stock
A final exception to the recognition of COD income is defined under Sec. 108(e)(8). This provision states that a creditor that receives stock in the debtor corporation in exchange for the cancellation of the outstanding debt will be deemed to have satisfied the indebtedness with an amount of money equal to the FMV of the stock received. In the event the FMV of the company’s stock is less than the outstanding debt forgiven, the company will recognize COD income on the excess of the principal forgiven and FMV of the stock received.Cancellation of Debt Involving Title 11 or Insolvency of S Corporations
The special relief provisions of Sec. 108 noted above also apply to S corporations. It should first be noted that insolvency must be determined at the corporate level (Sec. 108(d)(7)). Nontaxable income from the cancellation of indebtedness of an S corporation that is excluded from the S corporation’s income because the corporation is bankrupt or insolvent is not a passthrough item and does not increase the basis of any shareholder’s stock (Sec. 108(d)(7)(A)). However, this rule does not apply to taxable COD income. As with any other type of taxable income, taxable COD income passes through to the shareholders and increases their stock basis.S corporations that obtain relief under Sec. 108(a)(1)(A) or (B) must also reduce their tax attributes as outlined under Sec. 108(b) with the following notations:
1. For S corporations, any corporate loss or deduction disallowed at the shareholder level, during the year of discharge, will be treated as an NOL (Sec. 108(d)(7)(B)). Prior C corporation NOLs will not be reduced because no C corporation NOL can be carried forward into an S corporation tax year (Sec. 1371(b)(1));
2. Any unused general business credits generated in the year of discharge or carried forward from a prior C corporation tax year;
3. Minimum tax credits from prior C corporation tax years;
4. Capital loss carryovers from prior C corporation tax years;
5. Basis of property;
6. Passive activity losses; and
7. Foreign tax credits.
Conclusion
As noted above, the recent economic downturn coupled with the tightening of the credit markets has forced many corporate taxpayers to consider settlements with their creditors or possibly file for Title 11 bankruptcy protection. Until the credit markets soften and the economy begins trending positive again, many corporate taxpayers will use the relief afforded in Sec. 108. The mechanics and intricacies of this Code section should be explored by corporate taxpayers considering any form of negotiated debt settlement. By properly structuring the settlement or financial reorganization, the taxpayer will be able to maximize the COD relief provisions of Sec. 108.EditorNotes:
Frank J. O’Connell Jr. is a partner in Crowe Chizek in Oak Brook, IL.
Unless otherwise noted, contributors are members of or associated with Crowe Chizek.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or foconnell@crowechizek.com.
