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Federal income tax issues lurk behind any debt restructuring or debt workout that a creditor may arrange with a troubled borrower. In the current economic downturn, there is a growing need for creditors to work with troubled borrowers to reduce outstanding debts and modify obligations. However, such decisions carry consequences, and there are several implications—for creditors and troubled borrowers—worth consideration.
Tax Implications of Restructuring for Troubled Borrowers
Without careful planning, the benefits of debt restructuring can be lost, by triggering cancellation of indebtedness income (“COD”). COD generates taxable income under federal income tax law because the release of the obligation to repay the whole or a portion of the indebtedness is equal to an accession to wealth. COD is problematic because troubled borrowers frequently lack the cash to pay the income tax on COD. For creditors to increase their chances of being repaid on restructured debt, it is important that they understand the basic triggers of COD, and work with the available exceptions to produce better tax results.
Troubled borrowers have several helpful exemptions from COD when they do not have enough losses to shelter COD. There also are statutory exclusions from COD that come with a trade-off. This means the troubled borrower will not pay taxes on the COD amount in the taxable year, but must instead recognize a portion of the excluded amount when selling assets. Such exemptions and exclusions include, but are not limited to, purchase price reduction exception , insolvency exclusion, and bankruptcy exclusion.
Tax Treatment Dependent on Details of the Restructuring
There is a critical tax difference between a pure debt restructuring and a restructuring which includes asset or entity interest transfers. The former can result in COD treated as ordinary income, while the latter may generate capital gains. This difference may not matter to a troubled borrower structured as a C-corporation, because C-corporations face no difference in tax rates on capital gains versus tax rates on ordinary income. However, for a partnership, an S-corporation, or individual troubled borrowers, utilizing assets or entity interest transfers may generate long-term capital gains income which may only be taxed at the current 15% long-term capital gains rate. This possibility of converting what might otherwise be COD taxable at a 35% federal rate into long-term capital gains taxable at a 15% rate creates an important planning opportunity. Thus, in any debt restructuring, it may be wise to consider the tax consequences of a foreclosure, the issuance of a deed in lieu of foreclosure, or a sale to a third party.
There are few financial transactions that do not have tax consequences. Creditors need to be mindful of such consequences when restructuring debt so they do not inadvertently create large income tax liability for troubled borrowers, which could further inhibit repayment.