News / May 12, 2020 Lender

By Ryan Gardner
Tuesday, May 12, 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. A couple of weeks ago we discussed the tax consequences to debtors of restructuring their debts. Today, however, we are going to highlight some of the key issues and planning opportunities for lenders (and/or holders) to consider as they face the prospect of borrowers defaulting on obligations owed to them, including the possibility of the complete worthlessness of the obligations owed to them.

First, just as debtors have to consider the consequences of modifying the terms of their obligations, lenders must also consider the relevant consequences of a debt modification transaction. Specifically, modifications to a debt instrument that are “significant” lead to a deemed exchange of the original debt instrument for a new debt instrument for tax purposes. Depending on the terms of the new debt instrument and the lender’s tax basis in the original debt instrument as of the date of the deemed exchange, the lender may be required to recognize gain or loss, unless the borrower is a corporation and the original and new debt instruments both constitute “securities” for purposes of the corporate reorganization rules. While in most instances a lender is unlikely to recognize significant income in connection with a debt modification (unless worthlessness deductions have previously been claimed), it is important for a lender to give careful consideration of these rules prior to restructuring the terms of any loan it holds.

Second, given the severity of the current downturn, a lender may not have the “pleasure” of merely modifying its note holdings. Instead in certain instances, a lender may be forced to convert all, or a portion, of their debt holdings to equity in the applicable issuer to have any chance of recovering its original (loan) investment. Depending on how the lender is treated for tax purposes (i.e., as a partnership or corporation) and, in the case of a corporate borrower, on the character of the debt as a “security” for purposes of corporate reorganization rules, these types of restructurings may also trigger taxation to creditors in certain instances. Further, in the case of debt holdings in a corporate borrower, a lender will want to consider the impact of a conversion of its indebtedness to equity in the applicable borrower on the borrower’s use of its net operating losses (“NOLs”) going forward. It is important for lenders to understand these nuances in connection with any debt restructuring that involves a conversion to equity in the applicable borrower.

Finally, in the most extreme cases, there may not be any path forward for a lender to recover all or a portion of its original (loan) investment. In these cases, depending on the nature of the underlying debt as a security for tax purposes under Code Section 165 and the characterization of the borrower for tax purposes (i.e., as a partnership or corporation), a lender may be eligible for a loss or deduction for worthlessness (or for partial worthlessness in limited cases) under Code Sections 165 or 166, or a loss in connection with a debt “retirement” under Code Section 1271. In many of these instances these losses or deductions will be treated as capital losses for tax purposes. However, depending on facts and circumstances (such as characterization of the lender for tax purposes (i.e., as a corporation or partnership)) and the method with which a debt is retired or written off by the lender, there may be opportunities for certain lenders to generate ordinary deductions rather than realize capital losses, thereby avoiding all of the deduction limitations applicable to capital losses. Applicable law in this area is very complex and planning is critical to make sure that the debt retirement process is affected in the proper fashion to allow for the most tax efficient consequences.

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