News / April 27, 2020 Debtor Tax Considerations of Debt Restructuring

By Ryan Gardner
Monday, April 27, 2020

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To no surprise, many businesses are already finding it difficult, if not impossible, to service their debt obligations. As a result, many businesses are seeking to modify or restructure their debt, or, in more extreme cases, to have all or a portion of their debt forgiven or discharged. Many people are aware that restructuring transactions that results in the reduction or elimination of indebtedness can give rise to income – in the nature of: (i) “cancellation of indebtedness income” (“CODI”); and/or (ii) gain (or loss). However, most people probably don’t realize that a “mere” modification of a debt instrument (without an elimination or discharge of the applicable debt) may trigger the recognition of income. The principles that govern debt restructurings are undoubtedly very complex. Today, we will highlight some of the key planning opportunities for business debtors to consider in connection with modifying or restructuring their debt obligations.

First, it is well settled under applicable tax law, that savings realized by a debtor from the satisfaction of debt for an amount less than the amount due, generally will give rise to CODI to the extent of the difference between the amount due and the amount, if any, “paid” for its discharge. However, applicable law does provide for a number of exceptions/limitations (i.e., bankruptcy, insolvency, etc.) relating to the recognition of CODI by certain debtors. Notwithstanding the foregoing, because of a decision of the United States Supreme Court from almost 40 years ago, not all restructurings that result in all or a portion of the applicable indebtedness being discharged will result in CODI. Specifically, depending on the nature of the debt (i.e., whether recourse or nonrecourse) and the underlying property used to “satisfy” the debt, the applicable transaction may instead generate gain (or loss) to the debtor. Because the tax attributes and situations of all debtors are different, it may be preferable for certain debtors (including those that may be able to rely on certain income recognition exceptions to CODI) that are looking to restructure their debt to generate CODI (rather than gain (or loss)), while it may be preferable for other debtors to generate gain (or loss) (rather than CODI). With proper planning and execution, debtors may in many instances be able to use the applicable tax laws to their advantage (based on their particular tax attributes and situation) and minimize their recognition of income as a result of a restructuring transaction.

Second, even if a debtor’s obligations are not being reduced in connection with a restructuring, but are simply being modified (i.e., timing of payments being changed/delayed, collateral modifications, interest rate changes/reductions, etc.), debtors must understand that there is some risk that income may be inadvertently and unexpectedly triggered as a result of a deemed exchange for tax purposes of a new debt instrument for the original debt instrument. The key to the analysis is whether or not the modifications made in connection with the restructuring will be considered “significant”. With proper planning, debtors and creditors may modify their arrangements in a manner that does not trigger a deemed exchange for tax purposes. However, even in those situations where a modification is viewed as being significant, and thereby causing a deemed exchange for tax purposes, the consequences of the deemed exchange may be minimized, depending on whether the applicable indebtedness is publicly traded and/or whether an adequate interest rate is provided for with respect to the modified indebtedness.

The foregoing is merely intended to identify and highlight some of the basic tax issues and planning opportunities that should be considered by debtors in connection with any debt restructuring. Please understand that further rules and nuances may apply to the debt restructurings of pass through entities (i.e., partnerships, LLCs and S corporations). Further, while the focus of this email has been centered on business debtors, creditors also must consider the ramifications of restructuring their debt holdings. The authors likely will address certain of those issues in the coming weeks. The authors hope that you and/or your clients find this email informative should a debt restructuring become necessary in connection with your business ventures. If you have follow up questions please feel free to reach out to either of the authors of this email. Until next time, stay safe and have a great week!

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