Combining debtor and creditor positions: COD income considerations

Editor: Mo Bell-Jacobs, J.D.

Like all taxpayers, companies must realize any income that results from the cancellation of debt (COD). A COD event can occur in various situations, including an actual discharge or exchange of debt, as well as other events deemed to cause a discharge or exchange or otherwise satisfy the debt. In the context of merger–and–acquisition (M&A) transactions, the merging of debtor and creditor positions generally causes debt extinguishment.

In these situations — especially if the transaction otherwise qualifies for tax–free treatment — is the debtor absolved from realizing COD income (CODI), or does the debt extinguishment cause the debtor to have CODI? Often, the answer is unclear and depends on the type of transaction and its particular facts.

Overview: Cancellation of debt

Generally, taxpayers must include CODI in their gross income under Sec. 61(a)(11). The amount of CODI is equal to the excess of the debt’s adjusted issue price over the repurchase price, or the fair market value (FMV) of consideration (if any) received (or deemed received) in partial satisfaction of that debt (Regs. Sec. 1.61–12(c)(2)(ii)). Special rules may apply in given contexts, such as the discharge of debt between a company and its equity holders (Secs. 108(e)(6) and (8)).

In certain cases including insolvency or a discharge that occurs in a Chapter 11 bankruptcy, taxpayers may exclude all or a portion of CODI from gross income. A taxpayer generally then must reduce its tax attributes — e.g., net operating losses (NOLs), certain credits, capital loss carryovers, and asset basis — by the amount of any excluded CODI (Secs. 108(a) and (b)).

Transactions that combine debtor and creditor positions

What are common situations in which parties to an M&A transaction extinguish the debt they have with one another? One clear example of a situation in which the merging of debtor and creditor positions does not result in CODI is the tax–free liquidation of a solvent subsidiary that has debt payable to its corporate parent.

Example 1: Parent owns all the stock of Sub. Sub has assets with an FMV of $100 and owes a debt of $20 to Parent. Sub liquidates into Parent tax–free under Secs. 332 and 337. The Parent–Sub debt is extinguished in the liquidation. Sub first distributes its assets to Parent in satisfaction of the $20 debt payable to Parent. The remaining $80 of assets are distributed in cancellation of Sub stock. Sub does not recognize gain or loss on the distribution of its assets to Parent, including on those transferred in satisfaction of the $20 debt.

Sub does not realize any CODI because of the extinguishment of its debt to Parent in the liquidation (Regs. Sec. 1.332–7). Were Sub insolvent (and its dissolution taxable), it instead would realize CODI on its debt to Parent to the extent the adjusted issue price of the debt owed to Parent ($20) exceeds the FMV of assets transferred in satisfaction of such debt (Regs. Secs. 1.61–12(c) and 1.1001–2).

A similar result generally occurs in the case of an acquisitive, solvent tax–free reorganization under Sec. 368(a) where the target corporation has debt payable to the acquiring corporation. The target’s satisfaction of its debt to the acquiring corporation is part of the reorganization and appears to be covered by Secs. 357(a) and 361(a) (Rev. Rul. 72–464). Does this same result hold if the target’s liabilities exceed the FMV of its assets?

Example 2: Target has assets with an FMV of $80 and a $100 intercompany debt payable to Acquiring. Target has significant NOLs. Target merges with and into Acquiring pursuant to local law. Target and Acquiring are commonly owned, and assume the merger otherwise qualifies as a tax–free reorganization under Sec. 368(a)(1).

Target recognizes no gain or loss on its transfer of $80 of assets to Acquiring under Sec. 361(a). However, Target transfers assets to Acquiring in the merger that have an FMV that is $20 less than the $100 adjusted issue price of its liability payable to Acquiring. In essence, Target falls short of satisfying its intercompany liability using assets transferred to Acquiring pursuant to the merger. It is less certain in this case whether the operative reorganization provisions (e.g., Secs. 357 and 361) protect Target from realizing $20 of CODI. If Target realizes $20 of CODI that is excluded from income, its NOLs are reduced by $20 under Sec. 108(b). Similarly, Acquiring faces the uncertainty of whether it recognizes loss on the extinguishment.

The same questions can arise in the partnership context, where the character and timing mismatch between the income and any corresponding deduction or basis recovery on extinguishment is critical. Partnerships that transfer equity in satisfaction of debt — whether or not the creditor is a partner — realize CODI to the extent the debt’s adjusted issue price exceeds the FMV of the partnership interest received by the creditor under Sec. 108(e)(8). CODI realized by a partnership generally flows through to each partner according to their partnership interest.

The CODI is ordinary in character and allocated to the existing partners immediately prior to the COD event, while the regulations treat the exchange as a Sec. 721 exchange where the creditor recognizes no gain or loss and takes a basis in the partnership interest equal to its basis in the debt (Regs. Secs. 1.108–8(a) and 1.721–1(d)). As a result, even if a bad debt loss would otherwise result in an ordinary business bad debt, the Sec. 721 regulations disallow any bad debt and convert the loss into basis in the partnership.

With a partnership liquidation, the income tax results of the combination of debtor and creditor positions is again less clear. Does a debtor–partnership realize CODI in the same manner as satisfaction of debt with equity?

Example 3 (ignore accrued interest): Partners A and B equally own Partnership (an LLC under state law). In addition, B loaned Partnership $70 in exchange for a note (Partnership’s only liability). Partnership’s assets’ FMV declined to $20. Partnership liquidates for federal income tax purposes when Partner A abandons their interest (assuming A is able to accomplish such a feat). This results in a distribution of Partnership’s assets to B in a transaction that arguably is covered by Secs. 731 and 732.

Were Partnership treated as partially satisfying its $70 debt to B with its $20 of assets, it would realize $50 of CODI and potentially recognize gain under Sec. 1001. On the other hand, B would recognize a Sec. 166 bad debt expense (assume nonbusiness bad debt) or a Sec. 1271 extinguishment loss, each generating capital loss (Sec. 166(d) (short–term capital loss); Sec. 1271(a) (retirement of debt; sale or exchange treatment)). Here, the character mismatch is clear.

But is it appropriate to characterize the combination of debtor and creditor positions as COD that causes CODI? Is it possible that a COD event does not occur and that the operative nonrecognition provisions governing partnership liquidations cover Partnership’s distribution? A and B include their share of Partnership’s liabilities in the outside basis of their partnership interest. Partnership recognizes no gain or loss on its distribution of partnership property to A and B (Sec. 731(b)). A and B generally recognize no gain (or loss) on a distribution of property (Sec. 731(a)).

Perhaps Partnership’s nonrecognition treatment under Sec. 731(b) extends to the extinguishment of its debt to B, precluding realization of CODI or any corresponding loss or deduction (cf. Rev. Rul. 74–54 (positions merge in Sec. 332 liquidation; no CODI); Edwards Motor Transit, T.C. Memo. 1964–317 (positions merge in reorganization; no CODI)). Like Example 2, the reorganization of an insolvent target, the answer is uncertain. Perhaps this constitutes a transaction that would otherwise fall under Sec. 1271 as a retirement, but because it occurs as a part of a Sec. 731 liquidating distribution, there is no gain or loss, and the rules of Sec. 732 will apply to determine B’s basis in the assets.

Stepping outside otherwise tax–free transactions, consider the result if the partners of a distressed and insolvent partnership grant all their equity rights to a third–party creditor.

Example 4: Partners A and B equally own LLC, a partnership for tax purposes. LLC has a $100 debt that it owes to Creditor, but its assets have an FMV of $20. A and B agree to transfer all the units in LLC to Creditor, who becomes the sole owner of LLC.

LLC goes from a partnership in the hands of A and B to a disregarded entity in the hands of Creditor (Rev. Rul. 99–6, Situation 2). LLC’s $100 debt is extinguished because Creditor holds both the debtor and creditor positions. Is this an event that results in CODI? A and B are treated as transferring their partnership interests to Creditor in a taxable sale that will result in gain or loss. With the sale of a partnership interest — and in contrast to an asset sale — A and B do not have Sec. 1231 gain or loss. Their amount realized will include their share of Partnership’s $100 liability. From Creditor’s perspective, Partnership is treated as liquidating, with Creditor acquiring LLC’s $20 of assets in exchange for its $100 note (and capitalizing transaction costs into the assets acquired).

Under this characterization, it is possible that Creditor has an $80 bad debt deduction but realizes no CODI. Instead, A and B recognize gain or loss upon disposition of their interests under Rev. Rul. 99–6. This result is not an anomaly but rather is one of a number of situations where this ruling arguably creates disparate treatment.

Assessing the potential for CODI

The merging of debtor and creditor positions results in debt extinguishment for tax purposes. There are M&A transactions in which this can occur even beyond the scope of this item. There are situations where the provisions that apply to an otherwise tax–free transaction could also prevent CODI. In other cases, such as a Rev. Rul. 99–6 transaction, the disparate treatment of the buyer and seller could produce an extinguishment without the realization of CODI. In cases involving the merger of debtor and creditor positions, companies must assess the potential for CODI, especially with distressed or insolvent businesses.

Editor

Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP.

For additional information about these items, contact the author(s) at the email address(es) below.

Contributors are members of or associated with RSM US LLP.

Authors

Nick Gruidl, CPA, MBT (Nick.Gruidl@rsmus.com), Charlotte, N.C.; Eric D. Brauer, J.D., LL.M. (Eric.Brauer@rsmus.com), Washington, D.C.; and Nate Meyers, J.D., LL.M. (Nate.Meyers@rsmus.com), Alpharetta, Ga.