Negotiations between a company in financial distress and its lender can often involve forgiving all or a portion of the debt. In this situation, the borrower must realize and factor into its analysis that under many circumstances the forgiven amount constitutes income that gives rise to a tax liability.1 Although this is primarily a borrower issue, a lender should be aware of and understand the issue, as it will likely affect the borrower’s motivations and the ultimate resolution.
General Rule
Under the Internal Revenue Code, when a debt is discharged, unless there is an exception or exclusion that applies, the cancellation of that debt constitutes income (COD income) that must be reported for federal tax purposes and is taxable.
Forgiveness of Interest
One of the exceptions from COD income involves cancellation of a debt that would have been deductible if paid. Since in a business loan situation interest is generally deductible by the borrower, forgiveness or reduction of interest generally would not generate taxable income to the borrower.
Owners and Guarantors
If the borrower is a so-called pass-through entity (e.g., Subchapter S corporations, partnerships, and limited liability companies taxed as partnerships), the borrowing entity does not pay income taxes, but its income and losses are passed through to its owners. In these cases, the owners (i.e., shareholders, partners, or members) will have taxed on the COD income (in the absence of an exception or exclusion) in proportion to their ownership. On the other hand, the canceled debt does not constitute COD income to guarantors of the loan (unless it is allocated to them as owners of a pass-through borrower as described above).
Bankruptcy and Insolvency Exclusions
The forgiven indebtedness is not included in the borrower’s income if the debt is discharged in a bankruptcy proceeding (Chapter 11 reorganization, Chapter 7 liquidation, or Chapter 13 individual reorganization). To qualify for this exclusion, the discharge must result from a specific court order or be in a plan of reorganization that is approved by the bankruptcy court.
Even in the absence of a bankruptcy, if debt is forgiven or cancelled at a time when the borrower is insolvent, some or all of the cancelled indebtedness may be excluded from income. The borrower is considered insolvent if its liabilities (including the debt forgiven) exceed the fair market value of its assets. The amount of the exclusion is capped at the amount by which its liabilities exceed the fair market value of its assets.
The analysis becomes more complicated when the debtor is a pass-through entity. For a Subchapter S corporation, if the corporation satisfies the bankruptcy or insolvency exception, the exception applies, reducing or eliminating the taxable income passed through to the shareholders. Conversely, for a partnership or an LLC taxed as a partnership, the bankruptcy or insolvency exception must be met at the partner or member level rather than at the entity level.
Even if the COD income is excluded under the bankruptcy or insolvency exclusion, the amount forgiven reduces certain favorable tax attributes otherwise available to the taxpayer, including, in order, net operating losses, the general business credit, the minimum tax credit, capital loss carryovers, tax basis in property, passive activity loss and carryovers, and foreign tax credit carryovers.
A borrower must take into account possible COD income and the resulting income tax ramifications when considering an arrangement that may include forgiveness or cancellation of debt. The rules are complex, and a borrower would be wise to consult a tax attorney, in addition to its restructuring lawyer, in order to fully understand the ramifications and possible tax exposure and factor it into its negotiations. It is also helpful for the lender to understand the possible scope of these issues to aid in its dealings with its borrower.
The Thought Leadership Committee of Barclay Damon’s Restructuring, Bankruptcy & Creditors’ Rights Practice Area issues alerts and blogs on an ongoing basis to keep clients, colleagues, and friends up to date on important developments in the insolvency space. If you have any questions regarding the content of this alert, please contact the authors, Robert Wonneberger, Thought Leadership Committee chair, at rwonneberger@barclaydamon.com; Andy Oppenheimer, Tax Practice Area co-chair, at aoppenheimer@barclaydamon.com; and Joslin Valiyaveettil, associate, at jvaliyaveettil@barclaydamon.com; or Janice Grubin or Jeff Dove, Restructuring, Bankruptcy & Creditors’ Rights Practice Area co-chairs, at jgrubin@barclaydamon.com and jdove@barclaydamon.com.
1In certain situations, significant modifications of publicly traded debt that do not include forgiveness or cancellation can give rise to taxable income. This involves a complicated, multifactor analysis and is beyond the scope of this alert. Tax ramifications to the lender are also beyond the scope of this alert.