United States

Contributing equity-holder debt to capital: What, that’s taxable?

Section 108(e)(6)’s taxpayer beneficial rule has important exceptions.

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Synopsis

Due to the COVID-19 crisis and its impact on companies’ cash flow, many companies have increasingly faced difficulties in meeting the payment obligations on their indebtedness. In an effort to de-leverage or to manage cash flow issues, a creditor who is also an equity holder in the borrower may choose to cancel the debt of the company. However, this cancellation, generally treated as a contribution to capital, can generate cancellation of debt (COD) income.

A corporate debtor in this situation may sometimes be able to mitigate COD income under section 108(e)(6) (addressing a shareholder who contributes debt to the corporation as a contribution to capital). Taxpayers, however, should be aware of several important caveats pertaining to section 108(e)(6):

  1. There is a second provision relating to taxpayers in this situation, section 108(e)(8). Although the transactions described in sections 108(e)(6) and 108(e)(8) can be economically identical, they can generate very different results.
  2. If the corporate debtor is insolvent, section 108(e)(6) may sometimes not permit the mitigation of COD income. This may depend on the degree of insolvency and the quantum of the debt contributed, as is illustrated by a recent IRS ruling.
  3. While a corporate debtor may mitigate COD income under section 108(e)(6), such treatment is not available to a partnership debtor.

Background to sections 108(e)(8) and (6)

In the situation described above, where a company’s debt is held by an existing equity holder, satisfaction of the debt typically takes place via one of two forms:

  • Form 1: The parties convert the debt into equity, i.e., the debtor corporation issues new stock or membership interests to the creditor in satisfaction of the outstanding debt.
  • Form 2: The equity holder contributes the debt obligation to the debtor as a contribution to capital with no legal issuance of debtor equity.

Though U.S. federal tax law often looks to the substance of a transaction for its characterization, section 108(e) is a rare instance in which form governs.  As explained further below, under section 108(e)(8), if a shareholder of a corporation holds debt of the corporation and converts the debt into stock (Form 1), the corporation must treat the excess of the adjusted issue price of the debt instrument over the stock’s fair market value (FMV) as COD income. If, instead, the shareholder contributes such debt to capital (Form 2), section 108(e)(6) often permits the debtor corporation to mitigate COD income.

Section 108(e)(8)

Section 108(e)(8) addresses Form 1 and provides that when a debtor company (corporation or partnership) transfers equity (stock or partnership interests) of the debtor company to a creditor in satisfaction of its debt, the debtor company is treated as having satisfied the debt with an amount of money equal to the FMV of the equity transferred. Thus, if the FMV of stock issued to a creditor is less than the adjusted issue price of the corporation’s debt instrument, which is often the case with a distressed corporation or partnership, the excess is COD income for the debtor corporation.

Example: T, an unrelated third party, holds a $100 D bond. D issues stock worth $60 in full satisfaction of the bond. D must recognize $40 of COD income (excess of adjusted issue price of the debt, $100, over FMV of stock issued, $60).

Section 108(e)(6)

Section 118 provides that contributions of capital to a corporation do not constitute gross income to the corporation. Section 108(e)(6), addressing Form 2, explicitly overrides section 118 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, as is typically the case, if the shareholder-creditor’s basis in the contributed debt is equal to the adjusted issue price of the debt, upon the contribution of such debt to capital, the debtor corporation will generally mitigate COD income entirely.

Interestingly, the transactions described in sections 108(e)(6) and 108(e)(8)—Forms 1 and 2—could be economically identical. A shareholder of a wholly owned corporation that contributes its debt in the corporation to capital is economically in the same position as if it received stock in exchange for the debt. In several letter rulings, however, the IRS has permitted section 108(e)(6) to trump the section 108(e)(8) realization rule for corporations whenever corporate shareholders cancel the corporation's debt in proportion to their shareholdings and the corporation does not issue new stock as part of the transaction. As described above, form generally controls—if no stock is issued, section 108(e)(6) applies, but if stock is issued, then section 108(e)(8) applies.

Example: 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, but the FMV of the debt has declined to $60. In order to meet certain debt covenants related to outstanding third-party debt owed by D, C contributes the debt to capital and receives no stock from D. 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. By contrast, if D had instead issued stock to C equal to the FMV of the debt, the exchange would have caused $40 of COD income.

Capital Contributions of Debt to an Insolvent Corporation

While section 108(e)(6) is usually available to a corporate debtor, practitioners should be mindful of situations in which a Form 2 contribution of debt is made to an insolvent corporation.  Insolvency may complicate whether a corporation can mitigate COD income under section 108(e)(6).

As discussed above, the corporation must acquire its debt from the shareholder as a contribution to capital in order to receive favorable treatment under section 108(e)(6). In order to be considered a contribution to capital, the debt must at a minimum have some value to the shareholder. In the case of a Form 2 contribution to an insolvent corporation, questions can arise whether the shareholder has in fact contributed any value to the corporation. If there is no capital contribution in a Form 2 debt forgiveness, then the corporation has COD income equal to its entire adjusted issue price (i.e., because the corporation satisfied $0 of debt).

Courts and the IRS have addressed whether a Form 2 contribution of debt to an insolvent corporation is a capital contribution in several situations. The answer to that question can depend on if the corporation becomes solvent or remains insolvent (or even “hopelessly insolvent”) after the Form 2 transaction takes place.

The IRS appears favorably disposed to section 108(e)(6) treatment of a Form 2 contribution of debt if the contribution results in the corporation becoming solvent. A recent private letter ruling, PLR 202112003, addressed the forgiveness of a debt the taxpayer owed to a foreign shareholder. The corporation was insolvent prior to the debt forgiveness but expected to be solvent as a result of the debt forgiveness. Citing section 108(e)(6), the IRS ruled that the corporation would not recognize COD income as a result of the debt forgiveness, except to the extent (if at all) that the adjusted issue price of the cancelled debt exceeds the shareholder’s adjusted basis in such debt. Notably, the IRS did not limit section 108(e)(6) treatment to the amount by which the corporation was solvent after the debt forgiveness.

Example: 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. D is insolvent (i.e., its liabilities exceed the FMV of its assets) by $80. In order to improve its ability to obtain third party financing, C contributes the $100 debt to capital and receives no stock from D. C’s contribution of the $100 debt to D likely constitutes a contribution to capital and is subject to section 108(e)(6) in full because such contribution has value to D. Consequently, C’s contribution of the debt to D does not result in COD income because the adjusted issue price and C’s adjusted basis in the debt both equal $100.

The outcome of a Form 2 contribution of debt is less clear, however, if a corporation continues to be insolvent or, even more strikingly, ‘hopelessly insolvent’ after the contribution. As with a Form 2 contribution that results in corporate solvency, however, the relevant question reverts to whether the shareholder contributed any value to the corporation. A Form 2 contribution of debt to an insolvent corporation is likely to have value to the corporation if it improves the financial condition of the corporation (e.g., by making it solvent), improves its ability to obtain additional financing, or otherwise serves a valid business purpose of the company. See e.g., Lidgerwood v. Comm’r, 229 F.2d 241 (2d Cir. 1956). By contrast, if the corporation is so hopelessly insolvent that the shareholder’s Form 2 contribution has no value because the debt is entirely worthless, then section 108(e)(6) is less likely to apply to the shareholder contribution of debt. See e.g., Mayo v. Comm’r, T.C.M 1957-9 (1957).

Forms 1 and 2 in the Partnership Context

Section 108(e)(8), addressing Form 1, explicitly addresses partnerships and provides that when a debtor partnership transfers a partnership interest to a creditor in satisfaction of debt, the partnership is treated as satisfying the debt with an amount of money equal to the FMV of the interest. Section 108(e)(8) states further that COD income recognized in the exchange is included in the distributive shares of the partners who were partners in the partnership immediately before the discharge of the debt.

Unlike section 108(e)(8), the 108(e)(6) beneficial rule addressing Form 2 is confined to corporations. Accordingly, a partnership whose partner contributes its debt in the partnership to capital must calculate its COD income following the rules under Sec. 108(e)(8). See McKee et al., Federal Taxation of Partnerships and Partners, ¶4.02[3] (2020). 

In a case where the partnership is insolvent, therefore, the FMV of the interest deemed issued in exchange for the debt would likely be zero, and the partnership may recognize COD income equal to the entire adjusted issue price of the debt contributed.

The 108(a) Insolvency Exception 

An additional section 108─related advantage corporations have over partnerships involves the insolvency exception. Under section 108(a)(1), COD income is excluded from an insolvent taxpayer’s gross income, but only up to the amount of the taxpayer’s insolvency. For purposes of this rule, a taxpayer is insolvent by the amount that the taxpayer’s liabilities exceed the FMV of the taxpayer’s assets, determined immediately before the discharge. (Although the taxpayer may exclude its COD income, it must instead reduce its tax attributes.)

Section 108(d)(6) sets forth an important distinction between corporations and partnerships: In the corporate context, the determination of insolvency takes place at the corporate level, while in the partnership context, the determination of insolvency takes place at the partner level. Accordingly, partners of an insolvent partnership do not obtain the benefit of section 108 if they are personally solvent.

Thus, the partnership structure has two potential downsides, when contrasted with the corporate structure: (i) section 108(e)(6) is not available to mitigate COD income, and (ii) partners of an insolvent partnership cannot exclude their share of COD income if they are personally solvent.

Conclusion

A discussion of some of these issues can be found in a prior RSM article, Discharge of Indebtedness: Conversion vs. Contribution of Indebtedness. We recommend taxpayers consult with a tax advisor prior to entering into a transaction involving cancellation or contributions of debt, especially when the debtor is a partnership or the solvency of the corporate debtor post-transaction is in question.