Taxation of Debt Cancellation – 11 Things to Know

BOSTON -- After the 2000 dot-com bubble burst, and again during the Great Recession following the 2008 financial crisis, we saw an uptick in debt forgiveness, workouts, and distressed M&A. And we expect to see the more of the same as we enter the Coronavirus Recession. The tax consequences of debt cancellation -- the “bad debt deduction” for lenders and “cancellation of debt income” (CODI) for borrowers -- can be esoteric and arcane, so to help in issue spotting, here are 11 things to know:

1. Not every liability is a “debt.”

Whether a lender is analyzing a bad debt deduction, or a borrower is assessing CODI, the first step is to be sure there is a bona fide debt. The tax regulations, in a typically circular fashion, describe a debt as “a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” There are scores of cases and rulings that define debt in all its permutations, but generally a debt is distinguished by (a) an unconditional obligation to pay; (b) a maturity date; (c) priority of payment over the borrower’s equity securities; (d) creditor’s remedies in case of default; and (e) the parties agree to call it a debt.

Note that stated interest isn’t strictly required and a debt can be convertible into equity (i.e., a debt needn’t be limited in its upside potential). So, most bridge notes to finance a growth company will be debt, even if the holder fully expects it to convert to equity.

A SAFE or KISS, however, is likely not debt unless it specifies otherwise (because it lacks an unconditional obligation to pay, a maturity date, or creditor’s remedies), though the exact tax classification of a SAFE or KISS is subject to debate. (See our blog post “Tax Treatment of the ‘SAFE’ and ‘KISS’,” August 23, 2018.) Similarly, an obligation that hasn’t ripened into a present liability (such as future rent or a guaranty) wouldn’t be considered a debt.

2. For lenders, it’s all about timing and character.

For lenders, the tax analysis around “bad debt” focuses on when the deduction or loss can be claimed, and whether it’s an ordinary deduction or capital loss. (Other than for C corporations, a capital loss can only offset capital gain and cannot be carried back.)

If the debt is a corporate bond with interest coupons or in so-called “registered form,” the bondholder may only claim a capital loss when the bond is completely worthless (i.e., no further payments will be forthcoming).

With respect to other debt, a C corporation may claim an ordinary deduction when the debt is completely worthless, or partially worthless if the corporation also writes the debt down on its books.

All other taxpayers (individuals, S corporations, trusts, etc.) may only claim a deduction or loss when a debt is completely worthless. But they’re stuck with a capital loss unless the debt was created in connection with the taxpayer’s active trade or business (not merely as an investment). Examples of such “business debt” include where a taxpayer is in the lending business, or who extends credit to customers in its business.

3. Nonrecourse debt is treated differently than recourse debt.

The word “nonrecourse” in the tax world can have different meanings, so when we say “nonrecourse” debt, we mean a debt that is secured by a pledge of collateral, but for which the borrower is not personally liable. That is, if the value of the collateral isn’t enough to cover the whole debt, then the lender has no right to recover the remainder from the borrower. If a borrower defaults on a nonrecourse debt and transfers the collateral to the lender in satisfaction of the debt, then the transaction is considered a sale that generates capital gain (not CODI) for the borrower. While capital gain can be subject to lower tax rates, the gain is not eligible for any of the exceptions to CODI (see #5 below).

4. Debt exchanges, partial repayments, modifications, and conversions can trigger CODI.

CODI doesn’t arise only from an outright forgiveness of debt. Unless an exception applies, a borrower will recognize taxable income upon any complete or partial satisfaction of debt for less than the debt’s issue price. Thus, if a borrower exchanges a new debt for an old debt, the borrower will have CODI to the extent the issue price of the old debt exceeds the issue price of the new debt. The “issue price” of non-publicly traded debt generally is the stated principal of the debt. For this purpose, a change in the terms of a debt generally is considered a debt-for-debt exchange if the change is economically significant. And no, a borrower cannot avoid CODI by causing a related party to acquire its outstanding debt. In that case, the borrower will be treated as acquiring its own debt.

A debt-to-equity conversion (including conversion of a bridge note) can also trigger CODI, because the conversion is treated as if the debt were satisfied for an amount equal to the FMV of the stock received. A more favorable rule applies to an existing shareholder who cancels debt as a capital contribution to a corporation (the debt is treated as satisfied for an amount equal to the holder’s tax basis in the debt), but the line between a debt-to-equity conversion and a capital contribution is very fuzzy.

5. There are BIG exceptions to CODI.

There are several important exceptions to CODI. For example, a borrower won’t have CODI to the extent the borrower is insolvent. However, any debt discharge in excess of the borrower’s insolvency amount will result in CODI. For this purpose, “insolvent” means the excess of the borrower’s liabilities over the fair market value of its assets immediately before the discharge of the debt. As another example, a borrower won’t have CODI if the debt is discharged under a Title 11 bankruptcy case.

For partnerships whose debt may be cancelled and the resulting CODI allocated among its partners, both the bankruptcy and insolvency exclusions are applied at the partner level. It doesn’t matter if the partnership is insolvent or in bankruptcy, only if the partner is.

There are additional exceptions for debts that would be deductible if actually paid or accrued, and debts owed by buyers to property sellers, whose cancelation or modification is treated as merely an adjustment to the purchase price.

These CODI exceptions come at a price, forcing a taxpayer to reduce its other tax assets, such as net operating loss and credit carryovers, tax basis in depreciable assets, etc.

6. Forgiveness of loans to service providers may be compensation.

If an employer provides a loan to an employee, consultant, or other service provider (whether to finance the purchase of equity of the employer or to serve as a cash advance), the forgiveness of the loan may be considered compensation, subject to employment taxes.

While we’re on the topic, this is a reminder that credit extended to service providers to purchase equity of the employer should not be fully nonrecourse, secured only by the equity itself. The tax regulations provide that such an arrangement, that protects the recipient from substantially all depreciation in the value of the equity, is treated as just an option to purchase the equity. Let’s talk if and when this is an issue.

7. Watch out for cancellation of foreign corporation’s debts.

Generally, a shareholder of a corporation is not subject to tax on the corporation’s income. Rather, the shareholder will be subject to tax only when the shareholder either receives a taxable dividend from the corporation or sells its stock at a gain. However, under special “anti-deferral” rules for US shareholders of a “controlled foreign corporation” (CFC) or “passive foreign investment company” (PFIC), such shareholders may be immediately taxed on their pro rata share of the foreign corporation’s income. The details surrounding “global intangible low-taxed income (GILTI), “Subpart F income,” or “QEF elections” are complex, but just know that if a foreign corporation would have realized CODI if it were a US corporation, the US shareholders may be subject to immediate tax.

8. CODI can be UBTI for tax-exempt organizations.

Most tax-exempt organizations are subject to tax on their “unrelated business taxable income” (“UBTI”), which generally is defined as gross income from any trade or business unrelated to an organization’s tax-exempt purpose. Certain types of passive investment income are excluded from UBTI, such as dividends, interest and gains from the disposition of property (other than inventory). But UBTI also includes “unrelated debt-financed income” (“UDFI”), which generally is defined as any income derived from property in respect of which there is “acquisition indebtedness,” even if the income would otherwise be excluded in computing UBTI.

Tax-exempt organizations that invest in private investment funds are keenly aware that UBTI earned by a partnership flows up to its partners. For example, if a tax-exempt organization invests in a private investment fund that incurs acquisition indebtedness, then all or a portion of the income or gain attributed to the debt-financed property would be included in UBTI regardless of whether such income or gain would otherwise be excluded. CODI attributable to acquisition indebtedness or an unrelated trade or business will be UBTI. While CODI attributable to exempt income should not be UBTI, the analysis is not so clear.

9. There are special rules for real estate (of course).

The Internal Revenue Code is riddled with special favors toward real estate investment, and the CODI rules are no different. In addition to the bankruptcy and insolvency exceptions, a taxpayer (other than a C corporation) escapes CODI on the cancellation of “qualified real property business indebtedness” – generally defined as debt secured by real estate that was incurred in the taxpayer’s active business to acquire, construct, reconstruct, or substantially improve the property. Further, a taxpayer who takes advantage of one of the CODI exceptions may elect to reduce its tax basis in depreciable property (e.g., buildings) in lieu of reducing NOLs or credit carryovers. For a real estate owner holding slowly depreciating buildings which it plans to hold for many years, the preservation of NOLs and credits at the sacrifice of tax basis can be a major benefit.

10. Title 11 bankruptcy has its advantages.

Strictly from a tax perspective, the resolution of debts in an actual Title 11 bankruptcy proceeding has advantages over out-of-court workouts. As mentioned, debts canceled by the bankruptcy court don’t trigger CODI regardless of whether the debtor is technically insolvent. A transfer of the debtor’s assets to a new corporation may be a tax-free “G reorganization” to the shareholders – the most flexible and permissive of reorganization structures. And perhaps best of all – for a troubled corporation whose most valuable asset may be its accumulated NOLs, such NOLs may be preserved if the reorganized company is majority owned by its pre-bankruptcy shareholders and creditors (and certain other requirements are satisfied).

11. 1099 reporting is limited.

For borrowers who think they have a reasonable position to avoid CODI but are concerned their creditors may send them an IRS Form 1099-C, such reporting is limited to financial institutions or lenders in the active business of making loans.

As always, this summary is for informational purposes only and is not tax or legal advice. Always consult a professional tax advisor for advice in light of a taxpayer’s particular circumstances.

For further information regarding debt cancellations, conversions, modifications, etc., or distressed M&A, please contact:

Travis Blais
(617) 918-7081
TBlais@BlaisTaxLaw.com

Michael Lieberman
(617) 918-7083
MLieberman@BlaisTaxLaw.com

Christopher Bird
(617) 918-7086
CBird@BlaisTaxLaw.com