Authored by Patrick Balthazor
As some taxpayers struggle with a tough economy, it is inevitable that some will be discussing loan restructurings with their lenders. This may take the form of reducing interest rates, extending payment terms or simply canceling all or a portion of the debt. In these situations, it is imperative taxpayers receive good advice from their attorneys and tax counsel. They must understand how the restructuring affects their cash position, in addition to knowing the tax consequences. All too often, taxpayers do not receive proper advice during the process, creating unfortunate results. Given the complexity of debt restructurings, especially on the tax side, it is always better to seek advice during the process rather than after.
This article provides guidance that will enable those going through the process of a loan restructuring to have a basic understanding of the consequences. Armed with knowledge, better decisions can be made.
The general rule is that income from the cancellation of debt (COD) is not includible in gross income if the taxpayer is insolvent, in bankruptcy or the debt is qualified farm indebtedness; however, the exclusion from gross income does not come without consequences. In most cases, it is more in the nature of a deferral of the consequences since certain tax attributes must be reduced. The attributes to be reduced include net operating loss carryovers, certain credit carryovers, capital loss carryovers and the basis of assets. There is a defined order in which the attributes must be reduced, but a taxpayer may elect to first reduce the basis of depreciable assets before reducing other attributes. The attributes are reduced after the tax is determined for the year of discharge. The reduction of tax attributes has the effect of deferring the consequences of the COD, allowing the taxpayer time to recover instead of facing the immediate consequence of having the COD included in current income. The detrimental effects of the reduced tax attributes are then dealt with in future tax years.
As mentioned earlier, the general rule applies if a taxpayer is insolvent and only to the extent that the taxpayer is insolvent. For this purpose, insolvency is defined as the excess of the taxpayer’s liabilities over the fair market value of the taxpayer's assets immediately before the debt discharge. For example, if a taxpayer has liabilities of $50,000 and assets with a fair market value of $40,000 immediately before debt is discharged, only $10,000 of debt discharge can be excluded from income as that is the amount of the taxpayer's insolvency. Any amount above that is included in taxable income. The purpose of the general exclusion rule is that the exclusion should only apply to the extent that a debtor is insolvent. It does not apply to the extent a debtor is made solvent after the discharge.
For taxpayers other than partnerships, insolvency is determined at the taxpayer level. There is an exception for partnerships. Partnerships pass the COD income through to the partners and the partners must each determine if they are insolvent and able to exclude the income.
There are times it is obvious a taxpayer is insolvent and able to take advantage of the insolvency exclusion. But, in many cases, the taxpayer may hold assets with fair market value not readily known. In these cases, it is strongly recommended an independent appraisal be performed. A reliable appraisal will mitigate disputes with the IRS.
In some cases, the entire amount of debt principal and accrued interest is simply canceled. This generally results in COD income in the amount of the principal that is canceled plus any accrued interest deducted by the taxpayer. Accrued interest that has not been deducted, such as by a cash basis taxpayer, is not considered COD income since no benefit was received from a deduction. The IRS has reserved in the regulations whether carryforwards of interest deductions under section 163(j) are considered deducted and could be COD income if canceled.
When debt is not canceled outright, the debtor and creditor often negotiate a modification of the loan terms. This can involve a change in the interest rate, an extension of the payment terms and a number of other changes. Most debt modifications result in what the IRS would deem a “significant modification.”
There are numerous examples of significant modifications defined in the regulations and the threshold for a significant modification is quite low. The importance of a significant modification to a debt instrument is that it triggers a deemed exchange of the old debt for new debt. It is this deemed exchange that may result in COD. If there is a significant modification, the old debt is deemed to be satisfied with an amount of money equal to the issue price of the new debt. As a general example, reducing the principal amount of a debt will, in many cases, lead to an issue price of the new debt equal to its revised principal balance. As the old debt is deemed satisfied with an amount of money equal to the issue price of the new debt (with a lower principal balance), there will be COD income since the old debt was deemed to be paid off at a lesser amount than the principal balance of the old debt.
As noted above, the issue price of debt that is modified is an important consideration in whether or not the modification results in COD. There are different rules related to the issue price of debt that is publicly traded versus debt that is not publicly traded. The issue price of debt that is publicly traded is its fair market value. For debt that is not publicly traded and has adequate stated interest, the issue price is its stated principal amount. Debt that is not publicly traded can often have many modifications, but as long as principal is not reduced and there is adequate stated interest, there is no COD.
Discussing loan modifications with your lender can be uncomfortable and stressful. Possessing a basic knowledge of the consequences can alleviate some this discomfort. The following points should always be kept in mind.
For more information on this topic, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.