More and more businesses are having difficulty paying their debts because of today’s tough economic conditions. Many businesses are turning to alternative ways to solve their liquidity issues, such as negotiating with vendors or lenders to accept less than what is owed or extend out payment terms.
This may be a short-term situation for many businesses, which will have to convince their vendors or lenders that, although they are experiencing difficulties now, their projections show the business will bounce back soon.
“Businesses are going to engage those vendors and banks to do what they can, because the alternatives to these parties, such as being a creditor in a bankruptcy, are worse,” says Paul W. Linehan, a member of the business restructuring department at McDonald Hopkins LLC. “But many companies are not coming back from that hiccup, which has led to more skepticism and made it harder to convince vendors and banks to take that next step.”
Businesses in this situation are doing whatever they can to survive and sometimes don’t consider the tax implications of reducing or modifying their indebtedness, a transaction that often generates taxable income. Fortunately, the Internal Revenue Code does provide relief from this income in many situations.
“There are exceptions to treating that transaction as taxable,” says Mark D. Klimek, chair of the tax practice group and member of the business department at McDonald Hopkins LLC.
Smart Business spoke with Linehan and Klimek about the tax consequences of renegotiation of indebtedness, how the stimulus act affects debt restructuring and the consequences of excluding income.
Are there any tax consequences resulting from the renegotiation of indebtedness?
The main tax issue that comes up is cancellation of debt, or COD, income. Borrowing money is not a taxable event because of the obligation to repay the loan. If a loan is not repaid, it will generally generate taxable income, because it’s a transaction where money was received and no corresponding deduction exists. That income is taxed at ordinary income rates, which can be significant since ordinary income for individuals is taxed at a much higher rate than capital gains.
Also, ordinary income cannot be offset with capital losses. Oftentimes when a business is renegotiating its indebtedness, other things are going on that generate capital losses. If the business has capital gains, it is not as significant an issue because the losses can generally offset the gains. However, because COD income is taxed as ordinary income, capital losses cannot be used to offset COD income. For all of these reasons, incurring COD income is a steep price to pay for restructuring debt.
Are there any ways to avoid income recognition from a renegotiation of indebtedness?
There are exceptions geared toward helping businesses better their financial position without incurring tax obligations that would wipe them out. The two most common are the bankruptcy and insolvency exceptions. Any business that has debt forgiven or modified pursuant to a bankruptcy proceeding will not recognize the COD income. If a business is insolvent — meaning the value of its assets is less than the amount of liabilities — the COD income can be excluded up to the amount of the insolvency.
There are other exceptions geared toward more specific situations. For instance, there is an exception where the debt forgiveness relates to indebtedness incurred to purchase real property used in a business. There is also a specific exception related to vendors if the payment has not been deducted for tax purposes. Talk with an adviser to learn more about these exceptions and determine the right exception to use. Generally, there is no limit to the number of times you can use these exclusions.
Using the bankruptcy exception to avoid recognizing COD income must be analyzed carefully. Unless the situation is dire, bankruptcy is the last resort for businesses. When a bankruptcy is filed, the case becomes public and every transaction is open to scrutiny. Filing a bankruptcy involves additional time and financial burdens, including the professional fees.
Use of the insolvency exception allows the company to be more discreet in its transactions. Consult bankruptcy and/or tax professionals to determine the best course of action.
How does debt restructuring affect companies that are not in serious financial trouble?
The COD rules apply to any taxpayer whether or not the taxpayer is in serious financial trouble. COD income for a healthier business can be very difficult from a tax standpoint, since the business cannot take advantage of the bankruptcy or insolvency exception. Fortunately, there is a new exception provided under the American Recovery and Reinvestment Act of 2009, which recognizes that businesses are more likely to engage in some type of restructuring transaction due to today’s economic conditions. Under the new law, if a business restructures its debt in 2009 or 2010, and the restructuring results in COD income, an election can be made to defer that income until 2014. At that time, the taxpayer begins making payments over a five-year period. If the business is not in sufficiently bad shape to use the bankruptcy or insolvency exceptions, this is a great tool to use in planning for these types of transactions.
However, there are a number of caveats with this rule. For instance, if the business is sold or a liquidation event occurs, including a subsequent bankruptcy, that tax obligation is accelerated. Also, no other exclusions can be used, such as the bankruptcy or insolvency exclusions, if you make this election. If the COD income is excluded this year, but the business ends up being insolvent in 2014, the insolvency exception cannot be used and the tax will have to be paid.
What are the consequences of excluding that income?
For most of the COD exceptions, including bankruptcy and insolvency, taxpayers have to reduce their tax attributes. For example, say I’ve got $1 million of COD income because my lender forgave $1 million of my debt, and I exclude it because I’m insolvent. I have to reduce certain tax attributes, such as net operating losses and asset basis (if I have them) by $1 million. For the new deferral provision, you don’t have to reduce your tax attributes, but must recognize the income beginning in 2014.
Paul W. Linehan is a member of the business restructuring department at McDonald Hopkins LLC. Reach him at (216) 348-5413 or [email protected]. Mark D. Klimek is chair of the tax practice group and a member of the business department at McDonald Hopkins LLC. Reach him at (216) 348-5453 or [email protected].
