As a result of the credit crunch and economic slowdown, an increasing number of businesses are facing difficulties in meeting the payment obligations on their indebtedness. In an effort to de-leverage, more and more creditors, particularly those also holding an equity position, are willing to accept repayment for less than the face amount of the debt. Apart from settling the debt in cash for less than its face value, there are other methods debtors and creditors may use to modify, reduce, or even eliminate debt. Depending upon the method, the tax implications may vary.
In general, satisfaction of debt for less than its adjusted issue price (within the meaning of Regs. Sec. 1.1275-1(b)) generates cancellation of debt (COD) income. This item addresses the federal income tax implications for debtors and creditors where:
- A shareholder-creditor (or partner) contributes a debt obligation of the debtor corporation (or partnership) as a contribution of capital; or
- The debtor corporation (or partnership) converts the debt owed to a creditor into stock (or a partnership interest).
This item is limited in scope to the above issues and will not address the application of the Sec. 108(a) COD exclusions for insolvent corporations and corporations in bankruptcy or similar proceedings.
Capital Contribution of Corporation’s Indebtedness: Sec. 108(e)(6)
Sec. 108(e)(6) overrides the provisions of Sec. 118 (which exclude contributions of capital from the gross income of the corporation) and provides that a capital contribution by a shareholder of the corporation’s own debt is treated as if the debtor corporation satisfied the debt with an amount of money equal to the shareholder’s adjusted basis in the debt. Thus, if the shareholder-creditor’s basis in the contributed debt is at least equal to the adjusted issue price of the debt, the debtor corporation will avoid COD income upon contribution of such debt. However, if the shareholder’s basis in the debt is less than the adjusted issue price of the debt, the debtor corporation will recognize COD income.
Example 1: Corporation D owes $100 to C, the sole shareholder of D. The adjusted issue price of the debt and C’s basis in the debt equal $100. In order to meet certain debt covenants related to outstanding third-party debt, C contributes the debt to capital. C’s contribution of the debt to capital does not trigger COD income to D because C’s basis in the contributed debt is equal to the adjusted issue price of the debt.
In situations in which the shareholder contributing the debt is not the sole shareholder, compensation and gift issues may arise if the benefiting shareholders are employees or are related to the contributing shareholder.
Special Rule for S Corps.
Under Sec. 1367(b)(2), if an S corporation is indebted to a shareholder, the shareholder’s basis in the debt is reduced for excess losses deducted by virtue of Sec. 1366(d)(1)(B). If the shareholder later contributes such debt to the S corporation, absent any provision to the contrary, the COD income of the S corporation would be computed with reference to the shareholder’s reduced basis in the debt. In order to prevent this outcome, Sec. 108(d) (7)(C) provides that for the purposes of Sec. 108(e)(6), a shareholder’s adjusted basis in debt of an S corporation will be determined without regard to any adjustments made under Sec. 1367(b)(2).
Example 2: D, an S corporation, owes $100 to one of its shareholders, C, who had $100 basis in that debt. C’s basis in his D stock is $50. C’s share of D’s tax loss for the year is $80. Under Sec. 1367(b)(2), C’s basis in the debt is reduced by $30 (excess of C’s share of D loss over C’s adjusted basis in D stock). C subsequently contributes the debt to D.
Under Sec. 108(d)(7)(C), the reduction in C’s basis in the debt under Sec. 1367(b)(2) is ignored for purposes of Sec. 108(e)(6). D does not recognize COD income because the adjusted issue price of the debt ($100) is equal to C’s basis in the debt (ignoring any reduction under Sec. 1367(b)(2)).
Issuance of Stock for Debt: Sec. 108(e)(8)
Sec. 108(e)(8) provides that when a debtor corporation transfers stock to a creditor in satisfaction of its debt, the debtor corporation is treated as having satisfied the debt with an amount of money equal to the stock’s fair market value (FMV). Thus, if the FMV of the stock issued to the creditor is less than the adjusted issue price of the debt instrument, the excess of the adjusted issue price of the debt instrument over the stock’s FMV is COD income for the debtor corporation. The provisions of Sec. 108(e) (8) will apply at the corporate debtor level whether or not the exchange of stock for debt qualifies as a valid reorganization under Sec. 368(a)(1)(E).
Example 3: T, an unrelated third party, holds a $100 D bond. D issues stock worth $60 in full satisfaction of the bond. D recognizes $40 of COD income (excess of adjusted issue price of the debt, $100, over FMV of stock issued, $60). D recognizes the COD income whether the exchange represents a Sec. 368(a)(1)(E) reorganization or is a taxable exchange.
Recapture of gain on subsequent sale of stock: Sec. 108(e)(7) contains special recapture provisions that state that if T takes a bad debt deduction on the debt prior to the exchange or recognizes a loss on the exchange, and subsequently disposes of the stock at a gain, the gain is “recaptured” as ordinary income under the rules of Sec. 1245 up to the amount of the bad debt deduction taken or loss recognized by T.
Sec. 108(e)(6) vs. Sec. 108(e)(8): Comparative Analysis
While Sec. 108(e)(8) exchanges require issuance of new stock to the creditor, no such stock is issued to the creditor in the case of contribution of corporate debt in a Sec. 108(e)(6) transaction. This difference may prove to be an important planning tool, especially with closely held corporations.
A sole shareholder’s interest in the corporation remains unaffected whether he or she receives additional stock from the corporation in exchange for the corporation’s debt or contributes the corporation’s debt as additional capital. Since the computation of COD income follows different rules depending upon whether the income is due to a contribution to capital or exchange of stock for debt, the sole shareholder of the corporation may structure the transaction in the most tax-efficient manner (though the IRS may challenge the form if the substance of the transaction differs from its form).
Example 4: Assume the same facts as in Example 1, except that D issues additional stock with a value of $80 to C in exchange for the note. Unlike Example 1, D recognizes COD income of $20 on the exchange (excess of adjusted issue price of the debt, $100, over FMV of stock issued, $80).
Since C continues to own 100% of D stock whether the debt is exchanged for additional stock or is contributed to capital, the tax implications are vital in structuring the transaction.
Another difference between Sec. 108(e)(6) and (e)(8) transactions is that while a contribution of capital as envisaged under Sec. 108(e)(6) is required to be from an existing shareholder of the debtor corporation, the issuance of stock as provided under Sec. 108(e)(8) may be to any creditor of the corporation, whether or not the creditor is an existing shareholder of the corporation.
Further, as discussed later, while the statute and recently proposed regulations address Sec. 108(e)(8) in a partnership context, the applicability of rules similar to Sec. 108(e)(6) in the partnership context is unclear.
Tax Treatment for the Creditor
A shareholder-creditor contributing the debtor corporation’s debt as a capital contribution generally does not recognize gain or loss on that contribution. However, the shareholder’s adjusted basis in the debtor corporation’s stock is increased by the shareholder’s adjusted basis in the contributed debt. The Supreme Court confirmed this treatment in Fink, 483 U.S. 89 (1987), providing that “the shareholder is entitled to increase the basis of his shares by the amount of his basis in the property transferred to the corporation” and that “[t]his rule applies not only to transfers of cash or tangible property, but also to a shareholder’s forgiveness of a debt owed to him by the corporation.”
In the case of stock for debt transactions, the tax treatment of the creditor receiving stock in exchange for corporate debt depends upon whether the exchange qualifies for nonrecognition treatment under Sec. 354 or 351. If it does, the creditor generally will not recognize any gain or loss on exchange of stock for debt, and the basis in the stock received will generally equal basis in the exchanged debt under Sec. 358(a)(1). If the transaction does not qualify for nonrecognition treatment, the creditor generally recognizes gain or loss equal to the difference between the FMV of stock received and the adjusted basis in the debt exchanged. In such a case, the creditor’s basis in the stock received will be equal to the stock’s FMV under Sec. 1012. If a creditor receives stock in exchange for accrued interest, nonrecognition treatment under Sec. 354 or 351 is generally not avaliable (see Secs. 354(a)(2)(B) and 351(d)(3)). Further, if the creditor is a cash-basis taxpayer and thus has no basis in accrued interest, the creditor will have income equal to the FMV of the stock received.
Applicability of Secs. 108(e)(6) and 108(e)(8) in the Partnership Context
The foregoing analysis discussed the COD implications for corporate debtors in cases of contribution of capital or exchanges of stock for debt. This section discusses the applicability of Secs. 108(e)(6) and (e)(8) if the debtor is a partnership.
Regarding the exchange of equity for debt in the partnership context, Sec. 108(e)(8) provides that when a debtor partnership transfers a capital or profits interest to a creditor in satisfaction of recourse or nonrecourse debt, that partnership is treated as satisfying the debt with an amount of money equal to the FMV of the interest. Sec. 108(e)(8) further provides that COD income recognized in the exchange is included in the distributive shares of partners who were partners in the partnership immediately before the discharge of debt.
Recently issued proposed regulations would, if finalized in their current form, provide that, in general, the FMV of a partnership interest equals the liquidation value, which is the amount of cash or property that the creditor would receive with respect to such equity interest if, immediately after the transfer, the partnership sold all its assets (including goodwill, going concern value, and any other intangibles associated with the partnership’s operations) for cash equal to the FMV of those assets and then liquidated (Prop. Regs. Sec. 1.108-8(b)(1)). Such liquidation value may be used in determining the FMV of a partnership interest only if certain conditions are met (see Prop. Regs. Secs. 1.108-8(b)(1)(i)–(iv)). If such conditions are not satisfied, the FMV of the transferred partnership interest is based on all the facts and circumstances.
An unfortunate consequence of an exchange under the proposed regulations is the deferral of any loss on the exchange. As addressed above in the corporate context, a creditor could recognize a loss as long as the exchange is not covered under Sec. 354; however, the proposed regulations treat the debt as property contributed to the partnership and as such would, if finalized, defer gain or loss. (See the preamble to the proposed regulations, REG-164370-05.)
Example 5: AB Partnership has $1,000 of outstanding debt owed to C, who is not currently a partner. C agrees to cancel the $1,000 debt in exchange for an interest in AB. The liquidation value of the interest received is $700. Under Regs. Sec. 1.704-1(b)(2)(iv)(b), C’s capital account is increased by $700 as a result of the equity-for-debt exchange.
Assuming the requirements of Prop. Regs. Sec. 1.108-8(b)(1) are satisfied, the FMV of the equity interest received by C is $700. Under Sec. 108(e)(8), AB will recognize COD income of $300 (excess of adjusted issue price of the debt, $1,000 over the FMV of equity interest transferred to C). The $300 of COD income is allocated to the AB partners who were partners before the exchange.
Regarding Sec. 108(e)(6), neither the Code nor the regulations provide any guidance as to whether similar rules apply in a partnership context where a partner contributes partnership debt to a partnership. In the absence of any clear authority, this issue is debatable; however, experts have pointed to the lack of a partnership carve-out in the statute and legislative history as perhaps indicating that COD income would occur upon such a contribution. See McKee et al., Federal Taxation of Partnerships and Partners ¶4.02 (Warren, Gorham & Lamont 2007). In such a case, presumably the COD income will be calculated following the rules under Sec. 108(e)(8) (id. at ¶9.02(a)).
Sec. 108(e)(4): Trap for the Unwary
As a result of current economic conditions, many third-party creditors are looking to de-leverage and are more likely than ever to extinguish debt at a discount. To many debtors, this is a mixed blessing in that the satisfaction of the debt at a discount will generally result in COD income. To avoid recognition of COD income, owners of the debtor corporation or partnership may attempt to acquire third-party debt and rely on either Sec. 108(e)(6) or (e)(8) to avoid COD income. In such situations, Sec. 108(e)(4) may contain a trap for the unwary by providing that the acquisition of debt by a person related to the debtor (as defined under Sec. 267(b) or 707(b)(1)) from a person who is not so related will be considered an acquisition of such debt by the debtor.
In the case of an acquisition of debt prior to becoming related, the regulations provide for a facts-and-circumstances test for determining whether debt was acquired by a holder in anticipation of becoming related to the debtor (see Regs. Sec. 1.108-2). However, a holder of debt is presumed to have acquired the debt in anticipation of becoming related if the holder acquires the debt less than six months before the date the holder becomes related (Sec. 1.108-2(f)). If Sec. 108(e)(4) applies, the amount of COD income is generally measured by reference to the related holder’s adjusted basis in the debt but may be measured against the debt’s FMV (Secs. 1.108-2(f)(1) and (2)). Further, if the debt remains outstanding, the debt is treated as newly issued to the related holder, and such deemed reissuance may result in the creation of original issue discount under Sec. 1273(a)(1) (Sec. 1.108-2(g)).
ConclusionWhen contemplating a debt restructuring, debtor corporations and partnerships need to pay close attention to Sec. 108(e), which provides planning opportunities as well as traps for the unwary.
Mindy Cozewith is director, National Tax, at RSM McGladrey, Inc., in New York City.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Ms. Cozewith at (908) 233-2577 or firstname.lastname@example.org.