Understanding whether a debt instrument includes qualified stated interest versus "paid-in-kind" (PIK) interest is critical in determining the deductibility and taxability of accrued interest not yet paid in cash or property. In addition, understanding when related-party rules may change the tax treatment of a debtor or creditor helps to ensure appropriate planning takes place to avoid unknown tax liabilities.
When a creditor is a cash-basis taxpayer, the taxability of "accrued interest" depends on whether the interest is truly accrued but unpaid interest or, alternatively, PIK interest. Where a debt instrument includes qualified stated interest (QSI) (interest at a stated rate unconditionally payable in cash or property other than additional debt instruments of the debtor) payable at least annually at a single fixed rate, such interest accrues during the debt instrument's accrual period (e.g., quarterly accrual) and then is paid in cash or property. To the extent a cash-basis taxpayer’s tax year ends during a debt instrument’s accrual period, the taxpayer will have accrued interest. Further, if the debtor is unable to make the QSI payments in cash or property, such interest will accrue as unpaid interest and will most likely be subject to a higher penalty interest rate. In both instances, the cash-basis creditor is not required to recognize the accrued but unpaid interest in income due to the application of the cash method of accounting (i.e., QSI should be reported under the taxpayer’s overall method of accounting–see Reg. section 1.446-2).
The answer for a cash-basis taxpayer changes significantly where the note calls for PIK interest. PIK interest accrues during the applicable accrual period and is then "paid in kind" through either the issuance of additional debt instruments or an increase in the principal of the existing debt. PIK interest is accounted for under the original issue discount (OID) rules for inclusion into income. Under these rules, a creditor is required to report the appropriate PIK interest as income in the current year, regardless of its method of accounting. Reg. section 1.1272-1(a)(1). Therefore, a cash method creditor holding a PIK note is required to include current interest into income regardless of when it receives cash payment. To some, this may come as an unwelcome surprise.
The difference between PIK and accrued interest on QSI debts often occurs in the context of related parties. For example, private equity (PE) firms often structure their investments in a portfolio with a mix of debt and equity, resulting in a situation where the PE firm owns in excess of 50 percent of the portfolio (P) and is also a creditor. Many PE investors and other non-tax professionals operate under a misconception that related-party rules serve to defer interest deductions on related-party debts until such interest is paid in cash. If not corrected early, this misconception can lead to unknown tax liabilities for debt holders.
Where P is an accrual-method taxpayer (which will generally be the case) with accrued and unpaid interest owed to PE (an accrual-method fund), the failure to pay the interest does not absolve PE from including the interest in income. Rather, as an accrual-method taxpayer, PE should include the interest in income until PE claims (and can support) that the debt has become uncollectible. However, taking such a position must be considered carefully. The result depends on whether PE enforced its creditor rights in significant enough a way to maintain the status of the interest as QSI (unconditionally payable), as well as whether the failure to enforce creditor rights would cause a debt modification under Reg. section 1.1001-3. If PE is a cash-basis taxpayer and the interest is properly determined to be QSI, the accrued interest would not be taxable, and section 267 would in fact defer the interest deduction by P until such interest is included in income by PE.
However, with respect to PIK interest, the related-party rules of section 267 do not provide for either deferral of the inclusion or deduction for PIK interest, regardless of the creditor’s method of accounting. Section 267 serves as a deferral mechanism where the deduction of one party is deferred until income is included by the other related party. With respect to PIK interest, the cash-basis debtor is required to include the interest in income currently to avoid a mismatching of current income and deduction between the debtor and creditor.
Unlike QSI, PIK interest is subject to the OID rules, meaning the deduction of interest expense or inclusion of interest income does not hinge on whether cash payments are made. Properly identifying a debt instrument as having QSI or PIK interest/OID is an essential first step in understanding the appropriate tax treatment for both the debtor and creditor.