DEBT RELIEF AS THE DRUG OF CHOICE:

Avoiding Severe Tax and Financial Statement Reactions

Joe Dawson and Nina Gerbic

Dawson & Gerbic, LLP

Seattle, Washington

INTRODUCTION

Structure of the Presentation

Creditors sometimes provide their debtors relief from the terms of existing liabilities, either voluntarily or involuntarily. When that occurs, debtors and their advisors often consider only the dollar amount and timing of the debt adjustment. They are often unaware of other potential financial consequences of the adjustment, of the rules governing those consequences, and of steps which could dramatically affect those consequences, until it is too late.

The purpose of this presentation is twofold. First, we will suggest an analytical framework for identifying the potential tax and financial statement implications of debt relief transactions which are typically encountered in workout and bankruptcy situations. Second, we will try to identify some combinations of concepts and rules which may enable you to convert potentially painful results of those transactions into opportunities.

We will not focus on the technical requirements of the debt adjustment taxation rules which you regularly hear described at conferences such as this one. We will mention many of those rules, as briefly as we can, to provide background and context for the main focus of our presentation. We will spend some time on some less frequently discussed rules, however. And our discussion will make use of numerous unsupported legal and factual assumptions, each of which could itself be the subject of an hour-long presentation.

Our presentation will begin by briefly identifying the more common forms of debt relief and their general treatment for tax and financial reporting purposes. We will then identify the tax treatments of various types of debt adjustment, either as an amount realized on a sale or exchange, or as discharge of indebtedness income (COD). We will address the relationship of those tax treatments to tax attributes such as loss or credit carryforwards and asset basis. And we will briefly explain some potentially surprising financial statement impacts of debt adjustment transactions.

Our presentation will not look solely at debt reductions, because other changes in debt terms can sometimes have equally significant effects.

Preliminary Summary

In the most common category of debt relief transaction a debtor transfers something to its creditor in at least partial exchange for the debt adjustment. In this type of transaction, a portion of the debt equal to the fair market value of the property given up is normally treated as an amount realized on a sale or exchange.

The tax treatment of sale or exchange transactions is governed by Internal Revenue Code (IRC) sec. 1001. In general, that IRC section calls for computation of potentially taxable gain or loss by subtraction of the property's adjusted basis from any amount realized on the property's disposition. That gain is then taxed, in some cases at favorable capital gains rates.

Any excess of debt reduction over the fair market value of property surrendered to the creditor in a sale or exchange transaction is normally treated as COD for tax purposes.

For financial statement purposes, if collateral or other assets are transferred in full settlement of loans, the debtor should recognize an ordinary gain or loss equal to the difference between the book value of the assets given up and their fair value. The debtor should also recognize an extraordinary gain on restructuring for the difference between the fair value of the assets given up and the book value of the debt.

Numerous other types of transactions can also result in COD for tax purposes. Reductions of debt with no offsetting property transfer normally produce COD. Shareholder contributions of debt to corporate capital can produce COD at the corporate level. COD can result from exchanges and modifications of debt contracts. IRC reclassification provisions, such as sec. 483, can produce COD. And COD can even result from acquisitions of debt, or of creditor entities, where there is no modification to the debt itself.

COD is generally taxed at ordinary income rates, based on IRC sec. 61(a)(12) and the related regulations. There are significant exceptions, however, most of which appear in IRC sec. 108. Some amounts which would seem properly characterized as COD are excluded from income realization for all taxpayers, and troubled debtors are sometimes able to exclude additional amounts which are characterized as COD from gross income for tax purposes. When the latter form of exclusion is available, however, there is often a price exacted in the form of a reduction in beneficial tax attributes.

ANALYTICAL FRAMEWORK FOR DEBT RELIEF EVALUATION

Is the Obligation "Indebtedness"

In general, adjustment of an obligation results in COD under IRC sec. 61(a)(12) or an amount realized on a sale or exchange under IRC sec. 1001 only if that adjustment is properly characterized as a discharge of indebtedness of the taxpayer. Therefore, the first step in evaluating the potential tax effects of a liability adjustment is a determination whether the liability is properly characterized as indebtedness for these purposes. If it is not indebtedness, its adjustment may still be a problem, but it is not today's problem.

Neither IRC sec. 1001, nor Treas. Reg. sec. 1001-2(a)(2), which covers discharge of indebtedness for purposes of that section, defines the term "indebtedness of the taxpayer". The regulation section references IRC sec. 108, however, and that IRC section does provide at least some guidance. IRC sec. 108(d)(1) states that indebtedness of a taxpayer includes any indebtedness for which a taxpayer is liable, or subject to which a taxpayer holds property.

The IRC sec. 108(d)(1) language solves some potential characterization inquiries. Non-recourse liabilities which are secured by property, for example, clearly constitute indebtedness under that IRC provision. IRC sec. 108(d)(1) fails to define indebtedness, however, so it leaves unanswered questions concerning the treatment of certain other types of obligations.

Various commentators suggest that indebtedness for purposes of IRC sec. 108 is probably created only where a taxpayer receives something of value, which it does not include in gross income for tax purposes, in exchange for the taxpayer's promise to pay. That standard has long-standing judicial support. See, E.G., Commissioner v. Rail Joint Co., 61 F2d 751 (2d Cir. 1932). And that standard provides a basis for exclusion of two frequently-encountered types of obligation from characterization as indebtedness.

Guarantors normally receive little or nothing of value which can be excluded from gross income at the time of their guarantees. Because of that, various commentators seem convinced that guarantees and similar contingent obligations should be excluded from characterization as indebtedness for IRC sec. 108 purposes. See Kennedy, Countryman & Williams, Partnerships, Limited Liability Entities and S Corporations in Bankruptcy, 13-19 (2000); Tatlock, 540 T.M., Discharge of Indebtedness, Bankruptcy and Insolvency, A-19 (2000), and the decisions cited therein.

To the extent that there is a bona-fide dispute over the existence or amount of a debt, there has clearly never been the required promise to pay. If the dispute is settled for less than the amount which the creditor originally claimed, the difference should not be considered indebtedness under the suggested standard.

The suggested standard for identifying indebtedness solves some definitional riddles, but it still leaves the proper characterization of many common types of obligations unclear. Tort claims arising from products liability, warranty claims and future rent obligations, for example, represent instances of potential indebtedness where it is difficult to identify or quantify any item of value which the taxpayer received in exchange. Fortunately, however, the next step is our proposed analytical framework effectively side-steps that difficulty in many situations.

Is the Adjustment to the Obligation Tax-free Whether or Not it is Discharge of Indebtedness?

The second step in our suggested analytical framework is the determination whether any governing provisions render our particular liability adjustment tax-free, whether or not it represents discharge of indebtedness. There are such provisions.

As examples, under IRC sec. 108(e)(2), no income is realized from discharge of indebtedness to the extent that payment of the indebtedness would give rise to a deduction for tax purposes. This provision effectively avoids taxability of the tort, warranty and rent claims mentioned above, whether or not those claims are truly indebtedness. The wording of this provision is significant; since no income is realized, the discharge has no effect on other tax attributes.

And under IRC sec. 102 almost every type of true gift creates no gross income to the recipient. The IRC sec. 102 exclusion is clearly broad enough to encompass cancellation of an obligation, at least in a non-business context.

Is the Adjustment to the Obligation Discharge of Indebtedness?

Discharge of Indebtedness Description

If a liability seems to be indebtedness of the taxpayer for tax purposes, and no special provision renders our particular adjustment of that indebtedness unquestionably non-taxable, the next step in our suggested analytical framework is the determination of the potential taxability of that adjustment. More specifically, the next step in our framework is determination whether our liability adjustment is properly characterized either as discharge of indebtedness which might be included in gross income as IRC sec. 108 COD or as an IRC sec. 1001 amount realized on a sale or exchange.

While IRC sec. 108(d)(1) provides at least a partial definition of indebtedness, the IRC provides no definition of discharge of indebtedness. The American Bar Association suggests a two-part test to identify potentially taxable debt discharge:

whether at the inception of a loan transaction borrowed funds were excluded from gross income because of an offsetting obligation to repay; and

if so, whether the taxpayer's obligation to repay has been cancelled, forgiven or reduced.

See American Bar Association Section of Taxation, Report of the Section 108 Real Estate and Partnership Task Force, Part I, 46 Tax Law. 209, 224 (1992).

The ABA test for discharge of indebtedness seems reasonable and readily applicable when the transaction in question is solely cancellation or reduction of a loan repayment obligation. But the characterization of transactions becomes more complex if something of potential value, other than cash, is surrendered in exchange for the debt adjustment. And, as mentioned in our introduction, that is the most common real world situation. Fortunately, however, there is authoritative guidance on the inclusion or exclusion from discharge of indebtedness and its statutory consequences of many of the more common types of exchange transactions involving liability adjustments.

Satisfaction of Indebtedness by Property Transfer

One of the most common exchange transactions involving debt adjustments is the satisfaction of debts with mortgaged property or with other property which the debtor owns. As previously mentioned, a transaction of this type is treated, at least in part, as a sale for tax purposes. Treas. Reg. sec. 1.1001-2(a)(1) states that the amount realized on a disposition of property includes liabilities from which the transferor is discharged as a result of the sale or disposition. Treas. Reg. sec. 1.1001-2(a)(2) then modifies that inclusion in the case of recourse liabilities by excluding any COD from the sale or exchange transaction computation.

Thus, where property subject to recourse debt is disposed of in satisfaction of the debt, and the amount of that debt exceeds the property's fair market value, the IRC sec.1001 regulations effectively bifurcate the transaction. There is sale or exchange gain or loss to the extent of the difference between the fair market value of the property and its basis, and there is COD to the extent of an excess of the debt over the property's fair market value. See Treas. Reg. sec. 1.1001-2(c) Example 8. This position is supported by the courts. See. e.g., Gehl v. Comm., 102 TC 784 (1994), affd 50 F3d 12 (8 Cir. 1995), cert den 616 US 899.

In what seems a counterintuitive twist, however, the regulations under IRC sec. 1001 treat the full amount of any non-recourse debt from which a transferor is discharged as a consequence of disposition of the property which secures it as a sale or exchange amount realized. That position, as reflected in Treas. Reg. sec. 1.1001-2(c) Example 7, prevents treatment of any portion of the debt adjustment as COD. And that position was mandated by the Supreme Court in Comm.v. Tufts, 461 US 300 (1983).

The Tufts decision and resulting IRC sec. 1001 regulations apply only when non-recourse debt is adjusted. In PLR 8918016, the Internal Revenue Service (IRS) took the position that the Bankruptcy Code sec. 506 provision that converts under-secured non-recourse debt to unsecured debt thereby shifts a subsequent adjustment of that converted debt from a sale or exchange amount received to COD. Arguably, therefore, the Tufts rule should never apply to a disposition in bankruptcy.

Furthermore, the Tufts decision and the resulting IRC sec. 1001 regulations apply only if the debtor parts with the debt's collateral security as part of the debt adjustment transaction. Not all adjustments of non-recourse mortgage debt are actually accompanied by disposition of the property securing that debt. Other property of equivalent value can be transferred to the creditor, for example. In that situation, the transaction should be bifurcated between sale or exchange and COD in the same manner as transfers in connection with recourse debt described above.

Satisfaction of Indebtedness Without a Property Transfer

Where there is no disposition of property, there is no sale or exchange. Instead, because IRC sec. 108(d)(1) defines indebtedness for IRC sec. 108 purposes to include indebtedness subject to which a taxpayer holds property, a debt adjustment where the debtor retains the collateral security is treated as COD.

In Rev. Rul. 91-31, 1991-1 CB 19, the IRS confirmed that when a holder of non-recourse debt who was not the seller of the property securing the debt discharges a portion of the debt but does not take the collateral, COD results from the debt modification. The Tax Court has adopted the same rule. See, e.g., Gershkowitz v Comm., 88 T.C. 984 (1987); Carlins v. Comm., T.C. Memo 198-79.

Therefore if, for example, a creditor reduced non-recourse debt to the value of the security in an attempt to assist a workout, without taking the property itself at that time, COD rather than a sale or exchange amount received results from that debt adjustment.

Transfer to Corporations

Corporate indebtedness is sometimes transferred to the debtor corporation, either by an existing shareholder as a contribution to capital or by a creditor in exchange for stock of the corporation.

In addressing the former type of transfer, where no property is actually exchanged for the debt adjustment, IRC sec. 108(e)(6) first withdraws the protection of IRC sec. 118, the IRC section which excludes contributions to its capital from a corporation's gross income. Next, that paragraph treats the corporation as having satisfied its indebtedness with an amount of money equal to the shareholder's adjusted basis in the indebtedness. Corporate COD is potentially created, equal to the difference between the face amount of the indebtedness and the stockholder's basis in that debt.

The latter type of transfer is actually just another form of debt adjustment in exchange for non-collateral property. And, consistent with the exchange treatment discussed above, IRC sec. 108(e)(8) treats the debtor corporation as satisfying its indebtedness with an amount of money equal to the fair market value of the issued stock. If that fair market value is less than the amount of the debt, as is quite likely in workout and bankruptcy situations, COD is created in the amount of the difference.

A brief summary of the theory and procedure for valuation of interests in business entities is attached as an appendix to these materials. As can been readily seen from that summary, the valuation of stock interests in troubled companies can be quite complex.

Because of this, the IRC sec. 108(e)(8) COD measurement rule presents a potential problem. But, because of the mechanics of business entity interest valuation, particularly the applicability of discounts, it also presents a still more significant potential opportunity.

Modification of Terms of Indebtedness

If the terms of a debt instrument are significantly modified, for federal income tax purposes there is a deemed exchange of the old debt for a new debt instrument. Under IRC sec 108(e)(10)(A), the debtor is viewed as satisfying the old debt with an amount of money equal to the issue price of the new debt. IRC sec. 1273(b)(3) sets the issue price of a debt instrument, where either the old or the new obligation is publicly traded, at the fair market value of the publicly traded instrument.

If neither the old nor the new debt is publicly traded, under IRC sec. 1274(a) the issue price of the new debt is its stated principal amount, unless the new instrument bears no interest or below market interest. In the event of inadequate stated interest, the issue price is determined by discounting all payments due under the new instrument at the applicable federal rate. These rules may reduce the issue price of the new instrument below its stated principal amount and cause the debtor to realize COD on the deemed exchange (discussed below under “Deemed Issuance of a New Obligation”). Issue price also affects the creditor’s gain or loss on the exchange (also discussed below under “Deemed Issuance of a New Obligation”).