Financially distressed businesses must not only navigate the minefields of potential foreclosure or debt restructuring, but may also be confronted with significant tax liabilities at the worst possible time. The problem arises because the foreclosure of property can trigger either taxable gain or cancellation of indebtedness income, and even a workout that avoids foreclosure or liquidation of the company may trigger cancellation of indebtedness income for the borrower. However, with planning, such tax consequences can often be minimized.
Taxes From Debt Forgiveness
When property is lost through foreclosure, a business may recognize taxable gain or cancellation of debt income depending on whether the debt was recourse or nonrecourse. When a business is financially distressed, it is common that the debt encumbering its property will exceed the fair market value of the property and, in turn, that the fair market value will exceed the basis in the property (due to depreciation deductions).
If the debt is recourse, the amount by which the fair market value exceeds the basis will be treated as gain, and to the extent the gain is due to a reduced basis from depreciation deductions, the gain may be taxed at rates higher than capital gain rates. The amount by which the debt exceeds the fair market value is cancellation of debt income since the lender could have, but did not, pursue a deficiency judgment against the borrower for this amount.
If the debt is nonrecourse, the business will have gain to the extent the debt exceeds the basis in the property. Again, this gain may be taxed at rates higher than the capital gain rate to the extent the gain arose from a reduced basis from depreciation deductions.
While it may seem unfair to have taxable income when the property is lost, this treatment reflects that the company took depreciation deductions based on debt it never paid, and thus deductions are "recaptured" through recognition of gain or cancellation of debt income.
A business may also have cancellation of indebtedness income if the debt is forgiven but the company is allowed to retain the property. In this case, and in the case of foreclosure of a recourse debt, the good news is that the company may be able to exclude or defer recognition of the cancellation of indebtedness income. These exclusions typically are not free, however, since the business will often have to reduce certain tax attributes (such as bases in assets or net operating loss carryovers). Nonetheless, the ability to defer tax liability may outweigh the offsetting sacrifices.
The cancellation of indebtedness income rules also create planning opportunities. For example, a business may reduce the amount of cancellation of indebtedness income to the extent it gives the lender an interest in the business, measured by the fair market value of that interest. In such cases, the lender may even be willing to grant a repurchase option, permitting the company to buy out the lender when it has the wherewithal to do so. The company may also be able to have a friendly party—but one unrelated for tax purposes—acquire the debt to facilitate a workout and avoid foreclosure and cancellation of debt income.
Taxes From Debt Modification
A business could also have cancellation of indebtedness income even if it is able to restructure the terms of the debt with its lender and stave off foreclosure or liquidation. If the modification of the debt is deemed to be a "significant modification," the modification is treated as a new debt issued in exchange for the old debt. In such case, the Tax Code applies the rules for original issue discount which are very complex and require careful consideration and navigation. If these rules apply, the borrower can have cancellation of indebtedness income and the lender could have original issue discount on the new debt and a loss on the old debt even if the outstanding balance of the debt is unchanged. Nevertheless, these consequences can be avoided, in the case of debt that is not publicly traded, if the interest is a fixed rate equal to at least the applicable federal rate and payment are due at regular intervals.
The tax consequences of a debt modification also may be avoided by structuring the modification so that it does not fall within the categories of a significant modification. Even then, the business must be careful to make sure that other terms, such as contingencies or deferred payments, do not trigger negative tax consequences.
Bankruptcy And Assignments For The Benefit Of Creditors
Finally, if the business cannot reach a mutually agreeable resolution with its lender, it may decide to file bankruptcy or enter into an assignment for the benefit of creditors, in which the business transfers its assets to an assignee who liquidates the assets and pays claims. These strategies also have tax consequences that should be borne in mind and managed to the extent possible.
Overall, each workout has its own facts, circumstances and characteristics. Financially distressed businesses are wise to involve get tax counsel in the early stages to help them achieve successful workouts.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.