For many companies the financial impact of the COVID-19 virus has been immense. In some cases, it will lead to restructuring of debt, and unfortunately, may even result in a bankruptcy reorganization. When involved in a debt workout or restructuring, it is critical that businesses evaluate their restructuring options. With effective analysis and planning, companies can maximize available tax benefits and mitigate tax costs associated with issues such as net operating losses, cancellation or modification of indebtedness, and the disposition of struggling subsidiaries.
Managing debt modifications
The law broadly interprets the term “modification” when applying the term to debt instruments. Almost any change to the rights of the debtor or creditor will represent a modification. If the modification reaches the level of “significant,” there is a deemed exchange of the debt, creating numerous tax consequences, including the potential for taxable gain to the issuing company on the deemed exchange. When the modified debt is not considered traded on an established market and the principal of the debt remains the same, the company is generally able to avoid gain recognition with appropriate planning and analysis. If the deemed exchange occurs with debt that is traded on an established market (a surprisingly broad category of debt instruments), the potential for gain recognition increases exponentially. Any company contemplating or negotiating a debt restructuring should carefully consider the impact of the debt modification rules prior to agreeing to the terms of the new or surviving debt.
Preserving NOLs and other attributes
Companies in the process of a debt workout or restructure often have significant net operating losses (NOLs), credit carryovers and other attributes available to potentially offset post-restructuring income. However, they can lose these attributes because of the restructuring. Proper planning can help preserve the tax benefits associated with tax attributes such as:
- Net operating losses
- Capital loss carryovers
- Excess credit carryovers
- Tax basis in company assets
- Tax basis in subsidiary companies
The form that a restructuring takes (i.e. bankruptcy, debt modification or exchange for equity, taxable acquisition of assets by creditors, etc.) will affect the survival or tax attributes. In any restructuring, the facts surrounding the modification or cancellation of the debt will drive the ability to preserve these tax attributes, and understanding the tax impact early in the process may allow a company to maximize benefits available in the post-restructuring period. Such planning may have to extend beyond the company itself to the shareholders and creditors.
Companies that file as a part of a consolidated group of corporations need to consider the impact of the consolidated tax return regulations. When the debtor corporation is a member of a consolidated group, an additional set of attribute reduction rules come into play that could reduce tax attributes of companies other than the debtor company.
The effect of bankruptcy on tax attributes
The decision of a company to file for bankruptcy protection is not an easy one and is generally not driven by tax motivations. However, the tax ramifications of a restructuring are a key piece of the puzzle. For companies reorganizing through bankruptcy, special rules under sections 382(l)(5) and (6) provide benefits that allow increased utilization of attributes post-bankruptcy. If section 382(l)(5) applies, the company’s surviving NOLs are available post-bankruptcy without limitation. However, qualifying for the benefit of section 382(l)(5) can be difficult. On the other hand, companies applying section 382(l)(6), while not free from the section 382 limitation, are allowed an increase in the amount of NOLs that they are eligible to utilize post-bankruptcy.
Dealing with an insolvent subsidiary
Section 165(g)(3) provides a potential tax savings opportunity for companies that own an insolvent subsidiary upon its liquidation, whether actual or deemed, or upon other dispositions of the subsidiary. Notably, section 165(g)(3) allows for the recognition of an ordinary loss rather than a capital loss on the liquidation or disposition of the subsidiary’s stock for both domestic subsidiaries of a consolidated group or foreign subsidiaries. In addition, the use of disregarded entities could accelerate the loss into a tax year prior to the actual disposition of the business and, in some cases, allow a loss on the investment without the disposition of the subsidiary’s business.
Opportunities to recognize a loss are likely to occur when winding down the subsidiary’s business or when there is an interested buyer for a subsidiary, but the subsidiary has liabilities (including intercompany liabilities) that exceed the value of its assets. A worthless stock deduction may be available through structural changes that do not include disposition of the subsidiary. Companies considering claiming a worthless stock deduction should look closely at intercompany debt to make sure it represents true debt for federal tax purposes and should also consider having a valuation of the subsidiary’s assets completed to document the insolvency.
Make the most of recent law changes
Congress and the Treasury are actively working to create and adopt rules intended to help distressed companies. RSM will provide updates as guidance evolves in these areas.
Pass-through rules may differ
The majority of businesses in the United States operate in a pass-through form, whether family or private equity owned. Where the company is not a C corporation but rather a Subchapter S corporation or partnership (including an LLC taxed as a partnership), the rules could provide quite different results. Perhaps the most significant difference is found in the application of the exclusions to recognition of cancellation of debt (COD) income under section 108. Where the COD occurs at the partnership or LLC level, the exclusions do not apply at the partnership or LLC level, but rather at the partner or member level. As a result, the bankruptcy or level of insolvency of the partnership or LLC is not what determines whether the COD is excludable by the partner or member. This may come as quite a shock to an unsuspecting partner or member who has always assumed that a bankruptcy at the entity level is sufficient to avoid taxation on COD. For an S corporation, the rules are not as drastically different from the C corporation rules in that attribute reduction occurs at the S corporation level; however, unlike C corporation shareholders, shareholders of an S corporation could recognize taxable income upon a COD event. In addition, the company owner’s basis in the company plays a significant role in determining their ability to utilize losses incurred.
Don’t forget employee benefit matters
Both opportunities and pitfalls related to existing employee benefit plans must be considered when restructuring a troubled company. Issues to consider will include whether the company should contemplate amending the employee’s retirement plan to reduce or eliminate future contributions, eliminating pension and executive deferred compensation plans, obtaining a waiver of the minimum funding standard, and various considerations regarding repurchase obligations. Companies owned by an employee stock ownership plan also must consider a wide variety of issues.
In summary, recent unfortunate events surrounding the COVID-19 virus have put many companies into a financially distressed position, which may result in a debt workout and potentially even bankruptcy. For these companies, taking advantage of every opportunity, including tax-planning opportunities, may lessen the impact.