Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Regarding the Advisability of a Prohibition on the Taxable Asset Sale to Creditors in Bankruptcy
Carl N. Pickerill*
Just over five years ago, the Service issued a Chief Counsel Advisory memo—CCA 2003-50-016 (CCA)—approving a reorganization transaction between a debtor corporation (Debtor) in Chapter 11 and its creditors. The parties structured the transaction as a taxable sale of the Debtor’s assets to its creditors,
seeking to avoid application of the tax-free reorganization provisions. Through a relatively complex series of transactions, the Debtor effectively transferred substantially all of its assets in return for cancellation of indebtedness and cash, retaining a small portion of presumably leasable or licensable assets. Because the IRS Chief Counsel’s Office concluded that the transaction did not fall within the definition of the reorganization provisions that govern tax-free reorganizations, the creditors were able to obtain a fair market value basis in the assets. And because the Debtor was in a title 11 case, it did not recognize ordinary income on the cancellation of indebtedness. Finally, because it had transferred substantially all of its depreciable assets to its creditors, the cancellation of indebtedness income (COD income) excluded under section 108 did not reduce the basis in any of those assets, instead reducing only whatever available net operating losses (NOLs) the Debtor had left over after the asset transfer to its creditors.
Going forward, the CCA permits a significant tax ploy for Debtors in bankruptcy—at a potentially significant cost to the public fisc—assuming that certain characteristics of the reorganizing Debtor are present. First, the fair market value of the bankrupt corporation’s assets should exceed the assets’ tax bases. Second, the debtor corporation should be at risk of losing whatever asset basis tax attributes it has as a result of application of section 108(b). If the Debtor anticipates realization of COD income equal to or in excess of its non-asset basis tax attributes, it will not recognize gain on the COD income if it undertakes a taxable transaction by transferring its assets to a new corporation. And if it preserves the basis in its assets by “selling” the assets to its creditors (who then receive a “step-up” in the basis of the assets), the creditors will then have the ability to take depreciation deductions on those assets in later years. It is in this not uncommon situation that the CCA’s holding is beneficial to the debtor and its creditors.
The CCA garnered attention in the tax press, was followed by a subsequent law review article, and has not attracted any further attention or commentary from the Service. The transaction has come to be known as a “Bruno’s sale” or “Bruno’s transaction,” presumably due to its first use having been attributed to the Bruno’s reorganization, and generally occupies a few pages in treatise and handbook chapters on corporate restructurings and tax attribute preservation (the remainder of this Article will use both the terms “CCA” and “Bruno’s” to refer to the transaction at issue).
One treatise, after noting the use of the transaction in the Bruno’s reorganization and its subsequent approval by the Service, had this to say: “While it is true that the recent Chief Counsel Advice discussed above did sanction the use of a Bruno’s transaction, it is unclear whether the IRS will continue to bless Bruno’s transactions in the future or whether it will consider this type of transaction abusive.”
The current literature in the tax press begs the question: was the CCA decided correctly? Will the Service eventually reverse course? What reasons would the Service have for reversing course? And would it be wise to do so? This Article addresses these questions and ultimately concludes it would not be wise for the Service to do so.
Part II briefly describes the Bruno’s arrangement at issue in the CCA. Part III addresses, in order, the principal criticisms of the Service’s treatment of the Bruno’s transaction. Each criticism occupies a separate Subpart within Part III. Part IV then argues that if the Service indeed intends to reverse its CCA ruling—against the advice put forth in this Article—it should do so quickly, before similarly situated debtors begin to rely on it extensively, creating
potential fairness concerns.
*Juris Doctor magna cum laude, Notre Dame Law School, 2008; Associate in Corporate Restructuring, Kirkland & Ellis LLP, Chicago, Illinois. I would like to thank Notre Dame Law Professor Lloyd Hitoshi Mayer for his continuous support, candid advice, and invaluable guidance throughout the preparation for and writing of this Article. I would also like to thank Daniel Murray, partner at Jenner & Block LLP, Chicago, Illinois and Adjunct Professor of Law at the Notre Dame Law School, for his comments and suggestions.