Understanding tax consequences of debt workouts and restructurings

Updated on May 18, 2022

When businesses grapple with the effects of an economic downturn, many companies need to restructure their debt obligations. Understanding available tax planning opportunities can help mitigate risk and preserve company value during a financial crisis.

Debt workouts and restructurings can be arranged either in bankruptcy or outside of bankruptcy. The tax ramifications will vary depending on both the structure of the transaction and whether a bankruptcy filing is involved. The most beneficial transaction structure will depend on the company’s particular facts and is not a one size fits all analysis. Having a clear picture of the specific facts and tax consequences at the outset of the restructuring can help position the company more favorably following moving forward.

Background

EXCLUSION OF INCOME FROM DEBT CANCELLATION

Income resulting from the cancellation of debt (COD) is excluded from a bankrupt or insolvent corporation’s gross income for U.S. federal income tax purposes.[1] In non-bankruptcy situations, exclusion is limited to the amount of the taxpayer’s insolvency.[2] For purposes of section 108, a taxpayer is insolvent in the amount that the taxpayer’s liabilities exceed the fair market value (FMV) of the taxpayer’s assets, determined immediately before the discharge.[3]

For a company treated as a partnership for tax purposes, insolvency is determined at the partner level rather than the partnership level for purpose of excluding COD income.[4] As a result, financially stable owners of an insolvent partnership often are not able to exclude COD income realized in a workout of the partnership’s debt. In some circumstances, however, partners may benefit from a special rule allowing them to account for part of the partnership’s debt when determining their own insolvency for the purpose of applying the COD exclusion.[5]

REDUCTION OF TAX ATTRIBUTES

A corporation that excludes COD income due to either bankruptcy or insolvency is required to reduce tax attributes. Sections 108(b) and 1017 provide corresponding rules that act to reduce the taxpayer’s basis in property owned at the beginning of the year following the discharge, generally by the amounts excluded from gross income under section 108.[6]

Net operating loss (NOL) carryforwards are an attribute subject to reduction. At the same time, section 382, which operates to limit the utilization of corporate NOLs and built-in losses following an ownership change, provides certain taxpayers with favorable rules for the utilization of NOLs upon emergence from the bankruptcy proceeding.[7] As a result, understanding the consequences of the interplay between attribute reduction and the section 382 limitation is critical to taxpayers contemplating bankruptcy.

Unless the taxpayer elects otherwise, attribute reduction occurs in the following order:

1. NOLs
2. General business credits
3. Minimum tax credits
4. Capital loss carryovers
5. Basis reduction of property
6. Passive activity loss and credit carryovers
7. Foreign tax credit carryovers[8]

The amount of attribute reduction is not affected by the limitation on utilization of the attribute under prior section 382 limitations. As a result, even NOLs that will never provide benefit to the taxpayer through utilization against taxable income can nonetheless provide benefit by absorbing attribute reduction and allowing the survival of other valuable tax attributes.

The taxpayer has the option to elect to reduce the basis of depreciable property prior to reducing other attributes.[9] This is an attractive option to taxpayers that expect to generate significant amounts of taxable income in the years immediately following the restructuring, as the election to reduce depreciable property first generally allows NOLs and certain credit carryovers to survive and offset current taxable income in place of future depreciation deductions. As discussed below in more detail, this election is particularly attractive to taxpayers qualifying under section 382(l)(5).

CONSOLIDATED GROUP ATTRIBUTE REDUCTION

Where the taxpayer is a group of corporations filing consolidated federal income tax returns (a consolidated group), an additional set of attribute reduction rules applies. These additional rules may result in attribute reduction to not only the member of the consolidated group realizing COD income, but to other consolidated group members as well.[10]

In general, the consolidated return regulations apply a look-through and across rule in determining attribute reduction.[11] The look-through rule applies to any directly owned subsidiary whose stock is subjected to tax basis reduction under the general attribute reduction rules above.[12] To the extent the subsidiary’s owner reduces its tax basis in the subsidiary’s stock, the subsidiary is treated as having incurred COD and applies the general attribute reduction rules at the subsidiary level.[13] If after applying the look-through rule the excludable COD exceeds attribute reduction, consolidated attributes across the group become subject to reduction.[14] However, when looking across the group, “inside” attributes of other members, such as asset tax basis, are not subject to reduction. Rather, reduction is limited to “outside” attributes such as NOLs and credit carryovers.[15]

OTHER BENEFITS OF SECTION 108

While the primary focus of this analysis is to address various debt workouts and the related application of the section 108 bankruptcy and insolvency exclusions, section 108 provides additional benefits found in sections 108(e)(5) and (i) that are worthy of note. Section 108(e)(5) provides exclusion where the COD relates to debt issued to the seller of property where the taxpayer was the purchaser. To the extent section 108(e)(5) applies, the basis of the acquired property is reduced by the amount of the COD.[16]

Section 108(i) was a COD income tax deferral benefit available for cancellation, reacquisition or modification of a business debt occurring after Dec. 31, 2008 and before Jan. 1, 2011. It is no longer available.

Analysis

While tax consequences alone do not drive a debt restructuring or workout, they are a significant issue requiring consideration. The most favorable tax structure for a corporate debt workout depends on the amount of NOLs and asset basis available before and after the debt discharge, the FMVs and tax bases of the company’s assets, the status of existing creditors, and the company’s ownership post-restructuring. In general, a structure will fall into one of three categories:

1. Bankruptcy reorganizations under Title 11 or a similar case;
2. Non-bankruptcy debt restructurings; or
3. Taxable asset transactions where former creditors acquire the assets of the company using a newly created entity.

The remainder of this analysis assumes that the debtor corporation is a stand-alone C corporation that is not a member of a consolidated group.[17]

BANKRUPTCY REORGANIZATIONS

A corporation (Lossco) will often benefit from a reorganization under Chapter 11 of the Bankruptcy Code where the company has significant NOLs or other attributes that could provide a future tax benefit post-emergence. However, the bankruptcy proceeding will almost always result in an ownership change falling under the purview of section 382. For corporations undergoing an ownership change in a bankruptcy proceeding, sections 382(l)(5) and (6) (subsequently referred to as L5 and L6) provide favorable rules to help limit the impact of the change.

Section 382(l)(5)

In a bankruptcy workout, Lossco’s attributes, including NOLs, are reduced through the provisions of sections 108 and 1017.[18] The benefit of an L5 workout is that section 382 does not apply to limit utilization of Lossco’s NOLs or built-in losses (BILs) that survive attribute reduction.[19] As a result, under the right set of facts, the L5 transaction is preferred. However, certain conditions must be met to achieve this favorable application:

1. Lossco must be in bankruptcy immediately before the transaction.[20]
2. The shareholders and creditors of Lossco (determined immediately before an ownership change) own (after the ownership change) 50 percent of the value and voting power of Lossco.[21]
3. Lossco cannot incur an ownership change under section 382 within two years following a change occurring during or as a result of the bankruptcy proceeding. Occurrence of a second ownership change will result in the limitation amount being zero following the second change.[22]
4. Lossco’s creditors must have held their debt for at least 18 months before the date that Lossco files for bankruptcy, or the debt must have arisen in the ordinary course of Lossco’s trade or business and have been owned at all times by the same beneficial owner.[23]
5. The losses and excess credits carried forward from the three-year period before the ownership change must be reduced by the deductions taken for interest paid or accrued on debt exchanged for stock (the “interest haircut”).[24]    

Example 1:

Assume Lossco has $500 million ($500M) of NOLs prior to declaring bankruptcy, $200M of depreciable property and $300M of debt discharged in the proceeding. Assume further that Lossco paid or incurred $30M of interest on debt that was exchanged for stock in the reorganization. Assuming that Lossco does not elect to reduce the basis of depreciable property before NOLs, upon emerging from bankruptcy, Lossco will have $170M ($500M - $300M - $30M) of NOLs available to offset taxable income without limitation. However, assuming Lossco elects to reduce depreciable property first, the $500M NOL is only reduced by $130M ($30M interest haircut + $100M COD in excess of depreciable property). As a result of the election, Lossco will have $370M of NOLs available to offset current taxable income without limitation.

Section 382(l)(6)

Taxpayers that either elect out of L5 or do not qualify for L5 treatment instead apply for L6. Lossco will elect out of L5 either because of the reduction to NOLs as a result of the interest haircut or, more often, because of the uncertainty surrounding the occurrence of a second ownership change, which would create a section 382 limitation of zero. Unlike under an L5, in an L6 the section 382 limitation does apply to NOLs and certain BILs. However, under L6, the section 382 limitation is computed immediately after the ownership change and takes into account the increase in value attributable to the COD. This recomputed value under L6 is not to exceed the value of the assets before the ownership change.[25]

Example 2:

Under the same facts as the first example, assume further that Lossco was insolvent by $100M and had assets with a value of $200M. After a $300M discharge, Lossco’s value for purposes of computing the limitation amount is $200M, which is the lesser of the value of the stock immediately after the discharge ($200M) and the value of the assets ($200M). Lossco would have $200M of NOLs following the attribute reduction. As a result, ignoring built-in gains and assuming a 4 percent applicable rate, Lossco’s annual limitation equals $8M per year. This example ignores the effect that built-in gains would have on the limitation. However, it is essential that the company consider the significant increases in the limitation that could result from recognized built-in gains through the application of Notice 2003-65.

Non-bankruptcy workouts

Practically speaking, a non-bankruptcy workout will generally occur where an ownership change is not expected or the parties wish to avoid the expense of a bankruptcy proceeding. The benefits of neither L5 nor L6 apply to a non-bankruptcy workout; however, the section 108(a)(1)(B) insolvency exclusion is available.

A non-bankruptcy workout may involve the creditors’ exchange of Lossco’s debt for newly issued equity in Lossco while Lossco’s tax attributes remain intact. Recently finalized regulations adopt the bankruptcy reorganization provisions for determining continuing ownership of an insolvent Lossco, which expands the scope of debt workouts representing reorganizations under section 368. [26] However, the workout may simply involve the restructuring of existing debt without the issuance of additional equity. In either case, COD income incurred in the workout is excludable only to the extent of the taxpayer’s insolvency.[27]  

Example 3:

Under the same facts as the first example, assume further that Lossco was insolvent by $100M and had assets with a value of $200M. The $300M discharge results in taxable income to Lossco of $200M, which is the amount by which the COD exceeded the insolvency. Assuming the $500M NOL was not limited prior to the workout, Lossco is allowed to offset the $200M of COD prior to reducing attributes for the excluded COD.[28] The remaining $300M NOL is reduced by $100M to $200M under the attribute reduction rules. Lossco’s value for purposes of computing the limitation amount is zero as Lossco was insolvent immediately before the workout.

TAXABLE ASSET TRANSACTIONS

Otherwise known as a Bruno transaction, this type of workout involves a taxable asset sale by Lossco to its creditors in exchange for Lossco debt.[29] Following the exchange, the creditors contribute the assets to a new corporation or a new limited liability company (Newco). As a result, Newco obtains a cost basis in Lossco’s assets equal to the FMV of the assets. Further, Newco does not succeed to Lossco’s tax attributes such as NOLs or BILs. Therefore, from the buyer’s (creditors’) perspective, sections 108, 1017 and 382 have no effect on the continuance of the business.

Creditors may pursue a Bruno transaction for both tax and non-tax reasons. From a tax perspective, a Bruno transaction is beneficial where attribute reduction or the section 382 limitation would significantly reduce the benefit of NOLs and credit carryovers and when the inside basis of Lossco’s assets is significantly lower than their value. This analysis may seem counterintuitive; however, the leveraged buy-out (LBO) boom of the past few years and application of general corporate tax principles can provide this result.

Example 4:

Under the same facts as the first example, assume further that Lossco was insolvent by $100M and had assets with a value of $200M. However, assume Lossco was acquired in an LBO that did not result in an inside basis step-up in the assets and that the inside tax basis of the assets was only $50M. As we see in example 3 above, Lossco’s NOLs will have little value to Lossco on a go-forward basis due to the section 382 limitation. However, by using the Bruno transaction structure, Newco will step up the basis of the assets to $200M, which will provide future tax deductions of $150M. This is a much better result than is found in example 3.

Summary

As is apparent from the examples above, a company’s particular circumstances will determine the most tax-efficient method of a debt workout. While neither the company nor its creditors intended on reaching this unenviable position, attaining a favorable tax outcome would soften the situation’s negative consequences. As the outcome is highly fact-driven, all workout options should be considered prior to moving forward with a workout plan.

[1] §108(a)(1)(A). All references to “section” or “§” refer to the Internal Revenue Code of 1986, as amended, and the Treasury regulations promulgated under the Code.

[2] §108(a)(1)(B), (a)(3).

[3] §108(d)(3).

[4] §108(d)(6).

[5] Rev. Rul. 2012-14.

[6] §1017(a).

[7] §§382(l)(5) and (6).

[8] §108(b).

[9] §108(b)(5).

[10] See Reg. §1.1502-28.

[11] See Reg. §1.1502-28(a)(2).

[12] Id.

[13] Reg. §1.1502-28(a)(3)(ii).

[14] Reg. §1.1502-28(a)(4).

[15] Reg. §1.1502-28(a)(2)(ii).

[16] §108(e)(5).

[17] A C corporation is any corporation that does not have an election in effect under section 1362 to be treated as an S corporation. 

[18] See §§108(a), 108(b), 1017(a) and 1017(b)(2) and accompanying flush language.

[19] §382(l)(5)(A).

[20] §382(l)(5)(A)(i).

[21] See §§ 382(l)(5)(A)(ii), 1504(a)(2).

[22] §382(l)(5)(D).

[23]§382(l)(5)(E)(i); Reg. §1.382-9(2)(i)(B).

[24]See §382(l)(5)(B).

[25]See §382(l)(6), Reg. §1.382-9(j).

[26] Reg. §1.368-1(e)(6). The difference in reorganization versus non-reorganization treatment can be significant to the creditor.

[27] §108(a)(3). See also §108(d)(3) for the defining of insolvency for purposes of section 108.

[28] §108(b)(4)(A).

[29] In Re PWS Holding Corporation, Bruno's Inc., Case No. 98-212 through 98-223 (SLR) (Bankr. D. Del), Second Amended Joint Plan of Reorganization dated 10/15/99, Second Amended Joint Disclosure Statement dated 10/15/99.