That the country is awash in troubled debt obligations is hardly news. Perhaps more newsworthy are the sometimes surprising tax consequences of revising this debt.1 This article gives a whirlwind overview of tax aspects of revisions of debt from both the debtors’ and the creditors’ sides.
Debtor Aspects
It is widely known that when an amount of debt is reduced, the debtor may recognize taxable income from the cancellation of debt (“COD”). COD income is the subject of Internal Revenue Code §108, a comprehensive discussion of which would consume several times the length of this article. In general, however, when a debtor’s obligation is reduced (including to zero) other than by payment, the debtor recognizes COD income (which is ordinary income) unless one of the many exceptions contained in §108 applies. The exceptions most likely to apply are:
– The cancellation occurs in a Title 11 proceeding (in the case of a partnership, at the partner level)
– To the extent the taxpayer is insolvent (taking assets at their fair market values and, in the case of a partnership, determining insolvency at the partner level) ? The indebtedness is “qualified principal residence indebtedness” or “qualified real property business indebtedness”
In the Title 11 or insolvency exceptions, the taxpayer is required to reduce its “tax attributes” in a specified order, up to the amount of the excluded COD. If the taxpayer does not have sufficient tax attributes, the exception to COD income still will apply. The attributes are net operating losses, certain credits and credit carryovers (reduced by one-third of the amount of the COD), capital loss carryovers, passive activity loss carryovers, and the basis of the taxpayer’s property. The taxpayer may elect to apply the reduction first to the basis of depreciable property, which frequently will be beneficial. In the case of qualified real property business indebtedness, the reduction is applied to the basis of depreciable property; this entire provision, however, is elective. In general, basis reductions are made under Code §1017. Under that section, certain property – interests in partnerships owning depreciable property and property held for sale to customers in the ordinary course of business – also can be treated as depreciable for these purposes. In the case of residence indebtedness, the COD reduces the basis of the taxpayer’s principal residence.
An important new provision was added to §108 in February 2009. This is §108(i), permitting COD income to be deferred (though not eliminated). The provision is elective, and to the extent it is elected the taxpayer must forgo the exclusions noted earlier. If §108(i) is elected, COD income realized in 2009 and 2010 is included in income equally over a five-year period beginning in 2014. This deferral ends on the disposition or cessation of the business to which the debt relates (and, in the case of an individual taxpayer, on death).
The provision uses terms giving the impression that there are serious limitations in scope. For example, the provision requires the “reacquisition” of an “applicable debt instrument.” When the definitions are worked through, however, it is reasonably clear that the provision applies to all COD income, subject to one important limitation: the debt must be issued either (i) by a C corporation or (ii) by another type of taxpayer in connection with that taxpayer’s trade or business. Hence COD income from personal debt (e.g., a home mortgage) cannot be deferred under this provision.
Since so much business is done in partnership form, it is worth noting that the way the provision deals with partnerships is odd: the election must be made by the partnership, rather than each partner. What if one partner wants to defer COD income while another does not? In Rev. Proc. 2009-37,2 the Internal Revenue Service solved this problem by clarifying that an election under §108(i) can be made for less than all of the partnership’s COD income, and providing that the partnership can allocate deferred vs. non-deferred COD income among its partners without regard to the usual “substantial economic effect” rules. This approach requires substantial coordination among the partnership and all its partners. Thus if it is desired to make use of §108(i) for partnership’s debt – and it seems likely that often it will be – the time for the partners to start coordinating matters is now, not just before the due date of the partnership’s return.
Creditor Aspects
From the creditor’s perspective, the most important tax results flow from the fact that under Reg. §1.1001-3, a “significant modification” of a debt instrument is treated as if the debtor and creditor exchanged the old debt instrument for one containing the new terms. The regulations defining a “significant modification” are long; in general, however, any modification of the principal amount of, or a relatively small modification of the interest on, the instrument will give rise to a deemed exchange.
The effects on a creditor are best shown by example.3 Assume several years ago Debtor, then financially healthy, issued its promissory note with a principal amount of $1,000, bearing interest at 7% per annum, payable annually. Creditor, which recently bought the note from the original lender for $600, reaches an agreement with Debtor reducing the principal amount to $700 and the interest rate to 5%. A deemed exchange of notes takes place between Debtor and Creditor which results in Creditor realizing a gain of $100: Creditor had a $600 basis in the “old” note, and is treated as receiving $700 – the principal amount of the “new” note – on the exchange.4 The fact that the “new” note may not actually be worth $700 is not relevant. A reduction in interest rate alone would have resulted in Creditor being treated as realizing $400 of gain ($1,000-$600). Because, as generally is the case, the reduction in interest is to a rate above the Applicable Federal Rate, the reduction does not affect the amount treated as principal for tax purposes.5 There are, of course, other tax factors that creditors acquiring distressed debt should consider. First, if it is permitted, there is an advantage to using the cash method of accounting. This avoids the potential of a dispute over whether the debt is sufficiently distressed to permit an accrual-method taxpayer not to accrue interest. The law in this area is not taxpayer-friendly. Second, when debt is purchased at less than face, there will be “market discount” that is treated as ordinary income even if gain otherwise would have been capital gain. However, unlike original issue discount, which even a cash-method taxpayer must accrue, market discount does not accelerate the time when income must be included; it simply changes its character.
Which leads to the next point: creditors should consider whether (without regard to the market discount rules) their gain and loss will be capital or ordinary in nature. This requires a determination, among other things, of whether the holder is treated as being in the lending business or a dealer in securities. These determinations also can affect other tax aspects, among them whether certain expenses are treated as miscellaneous itemized deductions, subject to the 2% floor.
In addition, under debt/equity principles, “new” debt issued by a very troubled issuer may be treated for tax purposes as equity. This could affect both the holder (resulting in payments of principal being treated as distributions) and the issuer (primarily for partnerships in which debt is necessary to prevent income to partners with negative capital accounts).
As noted at the outset, this article merely touches the surface of tax considerations relevant to revisions of troubled debt. A full understanding of the tax consequences and alternatives is a necessary tool for deciding on the best course for debtor and creditor.
Alan R. Johnson is a tax principal and attorney and Lisa Knee is a tax partner and attorney with the CPA and advisory firm Berdon LLP with offices in Jericho and New York City.
1. Among the many aspects of §108 not dealt with in this article are debt incurred in farming operations, student loans, acquisitions of debt by a person related to the debtor and issuance of equity for debt. There also are many tax aspects of troubled debt that are dealt with other than in §108, for example at-risk recapture and income realized by a partner as a result of shifts in the allocation of liabilities.
2. 2009-36 IRB 309
3. In the example, Debtor also will be affected by having COD income, subject to the rules discussed above, of $300.
4. If Creditor were the original lender (or had purchased the note at face), its basis would have been $1,000, so it would have recognized a $300 loss on the exchange.
5. If the rate is below the AFR, there would be original issue discount, which would affect the amount treated as the principal amount of the debt, and hence Debtor’s COD and Creditor’s gain or loss.
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