WORKING OUT AND RESTRUCTURING DISTRESSED DEBT TAX TRAPS AND TECHNIQUES TO ACHIEVE FAVORABLE OUTCOMES

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1 WORKING OUT AND RESTRUCTURING DISTRESSED DEBT TAX TRAPS AND TECHNIQUES TO ACHIEVE FAVORABLE OUTCOMES State Bar of Wisconsin Annual Convention May 6, 2009 Richard A. Latta Michael Best & Friedrich LLP One South Pinckney Street, Suite 700 Madison, WI (608) Michael Best & Friedrich LLP 2009

2 MISSION To legally reduce to a nominal amount the income tax paid upon debt and mortgage restructuring, workout or forgiveness of debt (a/k/a Cancellation of Debt or COD ) Michael Best & Friedrich LLP 2

3 VISION Create a toolbox that allows practitioners to address debt and mortgage restructuring, workout and forgiveness situations Michael Best & Friedrich LLP 3

4 WHAT S THE PROBLEM? If the bank is willing to restructure the debt and forgive part of it that s great! But United States v. Kirby Lumber Co., 284 U.S. 1 (1931) The U.S. Supreme Court established the rule that a debtor realizes (and must recognize) income when discharged of indebtedness. That is, when a debtor is relieved of indebtedness without full payment of the amount owed, the debtor realizes taxable income in the form of COD. In Kirby Lumber, the taxpayer issued bonds for which it received par value. In the same year, the taxpayer repurchased some of those bonds in the open market for less than their par value issue price. The Supreme Court held the taxpayer must recognize income in an amount (in that case $137,521) equal to the difference between the issue price and the repurchase price of the bonds. In so holding, the Supreme Court reasoned: As a result of its [taxpayer s] dealings, it made available $137, [of] assets previously offset by the obligation of the bonds now extinct Michael Best & Friedrich LLP 4

5 KIRBY LUMBER IS CODIFIED IRC 61(a)(12) says: [G]ross income means all income from whatever source derived, including (12) Income from discharge of indebtedness Michael Best & Friedrich LLP 5

6 HOW WILL YOU PAY THE TAX ON THE COD? 2009 Michael Best & Friedrich LLP 6

7 WHAT TRIGGERS COD/TAXABLE GAIN? The two most common COD events are: Forgiveness of debt Kirby Lumber; IRC 61(a)(12). Modification of debt/restructuring Treas. Reg Taxable gain under IRC 1001(c) arises where there is: Foreclosures, deeds-in lieu and other transactions where an asset is transferred to satisfy a debt. Rev. Rul , CB 12. A debt shift in a partnership that gives rise to taxable gain as a result of IRC 752(b) Michael Best & Friedrich LLP 7

8 BASIC TOOLS The principal tool to exclude COD is in one section IRC 108: Per the legislative history of the 1980 Bankruptcy Tax Act, Section 108 was enacted to permit taxpayers who otherwise would have taxable income resulting from forgiveness of debt to not be burdened with an immediate tax liability. See S. Rpt , C.B. at 624 (1980). But, there is no exclusion for taxable gain arising under 1001(c) Michael Best & Friedrich LLP 8

9 Five principal parts of IRC 108, which provides the exclusion from income for COD, are where the: Discharge occurs in bankruptcy (a Title 11 case); 108(a)(1)(A). Discharge occurs when the taxpayer is insolvent ; 108(a)(1)(B). Debt is qualified farm indebtedness ; 108(a)(1)(C). Debt discharged is qualified real property business indebtedness ; 108(a)(1)(D). Debt discharged is qualified principal residence indebtedness discharged before January 1, 2013; 108(a)(1)(E). There s also a new five-year deferral not exclusion for COD to 2014 to 2018 for COD arising in 2009 or 2010; 108(i) Michael Best & Friedrich LLP 9

10 NOTHING IS FREE SO WHAT S THE COST? The cost of exclusion of COD is the debtor must reduce tax attributes by the amount of the COD excluded. 108(b)(1). Unless all seven of the tax attributes listed in 108(b) are exhausted, the exclusion under 108 is not a permanent exclusion but is, in effect, a deferral of COD. If all seven tax attributes are exhausted, then the exclusion is permanent Michael Best & Friedrich LLP 10

11 WHAT ARE THE ATTRIBUTES? The seven attributes reduced under 108(b)(2) are: (A) Net operating losses (a/k/a NOLs ). (B) General business credits allowable under 38. (C) The minimum tax credit available under 53(b). (D) Capital loss carryovers. (E) The tax basis of property of the taxpayer (note: this is tax basis and not depreciable basis more on this below). (F) Any passive activity loss or credit carryovers under IRC 469(b). (G) Foreign tax credits allowable under Michael Best & Friedrich LLP 11

12 AMOUNT OF REDUCTION The reductions are made after determination of tax for the taxable year in which the COD occurs. 108(b)(4)(A). For attributes in dollar amounts, the attributes are reduced on a dollarfor-dollar basis of the excluded COD. 108(b)(3)(A). For tax credits, the reduction is 33-1/3 cents for each dollar of excluded COD. 108(b)(3)(B) Michael Best & Friedrich LLP 12

13 SPECIAL ELECTION FOR DEPRECIABLE PROPERTY The attribute reduction under 108(b)(2) for basis is for any basis of the property of the taxpayer. 108(b)(2)(E). Under IRC 108(b)(5), there is a special election to apply the attribute reduction first against depreciable property. As a result of applying the attribute election against depreciable property, this special election: Reduces future depreciation of the taxpayer thereby highlighting the deferral aspect of 108. Only applies to depreciable property -- so land and other assets that are not depreciable don t qualify for the special election Michael Best & Friedrich LLP 13

14 COD FROM BANKRUPTCY The exclusion from COD arising in bankruptcy only applies if: The taxpayer is under the jurisdiction of the bankruptcy court; and The COD arises as a result of a forgiveness of debt by the court or pursuant to a plan approved by the bankruptcy court. 108(d)(2). So, the exclusion does not apply to COD that arises from a discharge either before the bankruptcy case or after termination of the bankruptcy Michael Best & Friedrich LLP 14

15 INSOLVENCY EXCEPTION In light of the stigma associated with bankruptcy, the most commonly used COD exclusion is the insolvency exception under 108(a)(1)(B). The term insolvent means the excess of liabilities over the fair market value of a taxpayer s assets. 108(d)(3). The test of insolvency is determined immediately before the discharge giving rise to the COD. 108(d)(3) Michael Best & Friedrich LLP 15

16 WHAT S AN ASSET? The definition of what is an asset for purposes of insolvency has been the subject of much litigation. The principal question is whether assets exempt from the claims of creditors under applicable state law are included in assets for purposes of the insolvency determination. Ultimately, this is a question of policy because under the bankruptcy exception assets exempt from creditors under state law are not treated as an asset of the taxpayer Michael Best & Friedrich LLP 16

17 IS THERE A FREEING OF ASSETS? After two decades of courts and taxpayers taking multiple positions on what is an asset, the tax court in Carlson v. Commissioner, 116 T.C. 87 (2001) held: The legislative history showed that the Bankruptcy Tax Act of 1980 adopted a freeing of assets theory. Hence, assets exempt from the claims of creditors under applicable state law are included when determining the fair market value of a taxpayer s assets for purposes of ascertaining whether the taxpayer is insolvent. The Court s rationale was if a taxpayer s total assets including exempt assets exceeds the debtor s liabilities, the debtor has the ability to pay an immediate tax on income from COD Michael Best & Friedrich LLP 17

18 WHAT S A LIABILITY? The term liability for purposes of insolvency was no easier to answer but only took 17 years after the Bankruptcy Tax Act of 1980 to resolve. In Merkel v. Commissioner, 109 T.C. 463 (1997), the Tax Court held that the term liabilities requires the taxpayer to prove that the taxpayer will be called upon to pay the obligation in the amount claimed. Failure to prove the taxpayer would be called upon to pay the amount of the obligation results in the obligation not being a liability for purposes of the insolvency determination Michael Best & Friedrich LLP 18

19 WATCH THE SPECIAL RULES In the case of individuals and C corporations, the tests for bankruptcy and insolvency are straight forward. The determination is made at the individual or C corporation level. For pass-through entities, the rules are not as easy Michael Best & Friedrich LLP 19

20 FOR PARTNERSHIPS Where the entity in bankruptcy or potentially insolvent is a partnership, then the exclusion of COD is applied at the partner, not the partnership, level. 108(d)(6). This means that if a partner is not in bankruptcy or insolvent, then the partner will have taxable COD from the discharge of debt, despite what s occurring with the partnership Michael Best & Friedrich LLP 20

21 WHAT ABOUT S CORPS? For S corporations, the provisions of 108 are generally applied at the S corp level. So, if the S corp is in bankruptcy or insolvent, then the bankruptcy or insolvency determination is made at the S corp level, and not the shareholder level. 108(d)(7). This result was affirmed by Gitlitz v. Commissioner, 531 U.S. 206 (2001), which permitted basis for COD excluded by the S corp, thereby allowing utilization of NOLs by the S corp shareholders. This decision was reversed by Congress in 2002 (i.e., no basis for excluded income under 1367(a)). 108(d)(7) Michael Best & Friedrich LLP 21

22 OTHER SPECIAL RULES There are a series of special rules in 108(e) that can be traps for the unwary. They include: Accrued interest and expenses there is no income (i.e., no COD) to the extent that the payment of a liability would give rise to a deduction. 108(e)(2). This means if a cash basis taxpayer has not previously deducted the amount, then the forgiveness of the expense does not give rise to COD. Related party acquisitions of debt if a party related to an obligor acquires the obligor s debt, the acquisition is treated as if the obligor reacquired the debt, thereby potentially creating COD. 108(e)(4). The rule also includes an expanded definition of who counts as related that is broader than general relationship rules under the Internal Revenue Code Michael Best & Friedrich LLP 22

23 OTHER SPECIAL RULES (cont.) Stock for debt where a company exchanges stock for debt, the exchange will typically give rise to COD. 108(e)(6), (e)(7) and (e)(8). Partnership interest for debt while for many years taxpayers took the position that an exchange of a partnership interest for debt did not give rise to COD, in 2004 Congress changed the Code to provide that a partnership interest exchanged for recourse or nonrecourse debt gives rise to COD. 108(e)(8). Debt for debt exchanges also give rise to COD to the extent of the issue price of the new debt instrument (determined under the OID rules) exceeds the amount of debt discharged. 108(e)(10) Michael Best & Friedrich LLP 23

24 WHAT ABOUT LAND CONTRACTS? If there is a reduction in the purchase price between a seller and a buyer where a note between the seller and the buyer is reduced, then the reduction can be treated as a purchase price adjustment and not as COD. 108(e)(5). This special rule for purchase money debt reduction is especially helpful when the buyer is not in bankruptcy and not insolvent Michael Best & Friedrich LLP 24

25 WHAT IS RECOURSE v. NONRECOURSE DEBT? The definition of recourse and nonrecourse debt is one of the most difficult issues yet to be resolved. In light of carve-outs in loan agreements (e.g., liability of borrower for environmental issues), it becomes difficult to determine whether debt is recourse or nonrecourse Michael Best & Friedrich LLP 25

26 1001 GAIN RULES The 1001 rules regarding taxable gain highlight why it is important to determine whether the underlying debt is recourse versus nonrecourse. Recourse debt receives bifurcated treatment. Treas. Reg (c), Example 8. Nonrecourse debt gives rise to taxable gain. 7701(g) Michael Best & Friedrich LLP 26

27 BIFURCATED TREATMENT FOR RECOURSE DEBT Where a debt is recourse, then the amount of debt forgiveness that exceeds the fair market value of property transferred is treated as COD, and the fair market value of the property transferred becomes the amount realized for determining gain under Example 8, Treas. Reg (c) describes how this calculation works. It says: In 1980, F transfers to a creditor an asset with a fair market value of $6,000 and the creditor discharges $7,500 of indebtedness for which F is personally liable. The amount realized on the disposition of the asset is its fair market value ($6,000). In addition, F has income from the discharge of indebtedness of $1,500 ($7,500 minus $6,000) Michael Best & Friedrich LLP 27

28 IMPACT ON FORECLOSURE OF PROPERTY Although foreclosures typically result in an economic loss to the obligor and owner of the property, it is common for the owner of the property to realize taxable gain due to the low tax basis of the property. Although an involuntary act, foreclosure is treated as a sale or exchange of the property by the taxpayer. As shown by Example 8, the gain or loss from the foreclosure is determined in the same manner as an ordinary sale of property. For recourse debt, the amount above the fair market value of the property is then treated as COD. Under the applicable case law, the amount bid in at a foreclosure proceeding will, absent other evidence, be treated as the fair market value of the property. See Carlson v. Commissioner, 116 T.C. 87 (2001). In a foreclosure transaction where there s recourse debt, the transaction is bifurcated and treated as part sale or exchange under 1001 to the extent of the fair market value of the property, and part discharge of indebtedness resulting in COD Michael Best & Friedrich LLP 28

29 WHAT ABOUT IF THE DEBT IS NONRECOURSE? The amount realized upon the foreclosure of property securing nonrecourse debt is equal to the face amount of the debt discharged, regardless of the property s fair market value. Tufts v. Commissioner, 461 U.S. 300 (1983); 7701(g). The importance is that there is no exclusion for taxable gain. So while the tax rate for taxable gain is currently lower than COD, there are situations where taxpayers will have a better result with a recourse debt as compared to nonrecourse debt Michael Best & Friedrich LLP 29

30 SPECIAL RULE FOR REAL ESTATE DEVELOPERS After the recession, Congress enacted a special rule for real estate developers under 108(c). The election is voluntary and is useful where the debt was incurred or assumed to acquire, construct, reconstruct or substantially improve real property or, in certain cases, resulted from refinancing indebtedness incurred or assumed before January 1, (c)(3). One catch the election only applies with regard to reducing basis of depreciable real property. It does not apply to land or other nondepreciable real property Michael Best & Friedrich LLP 30

31 FORGIVENESS OF DEBT FOR PRINCIPAL RESIDENCES In the recession, certain taxpayers found that their house was worth less than the debt against it. However, they couldn t walk away because they would have to pay tax on the COD. 108(h). For tax years 2009, 2010, 2011 and 2012, taxpayers will be eligible to exclude from income COD arising solely from debt discharged if the debt is directly related to a decline in the value of the taxpayer s principal residence or the financial condition of the taxpayer. 108(a)(1)(E), (h)(3). The exclusion is generally limited to mortgages on principal residences of $2 million or less. The amount excluded reduces the basis of the taxpayer s principal residence Michael Best & Friedrich LLP 31

32 DEFERRAL AND RATABLE INCLUSION FROM BUYING BACK DEBT As part of the American Recovery and Reinvestment Tax Act of 2009, a new deferral rule was enacted allowing taxpayers for 2009 and 2010 to elect to include the COD from reacquiring debt for less than its face value over a five-year period beginning in 2014 and ending in (i). The election to have the five-year deferral to 2014 to 2018 contains rules for how to allocate debt for C corporations and for pass-through entities and authorizes the IRS to promulgate legislative regulations regarding the deferral. There are rules for acceleration of the deferral in the event of the death of a taxpayer, liquidation of the taxpayer (including in bankruptcy) or cessation of business by the taxpayer Michael Best & Friedrich LLP 32

33 WHAT IF OBLIGOR IS A RELATIVE? If the debtor is related to the lender as a family member, then the IRS takes the position that cancellation of the debt is a gift. If the amount of the gift exceeds the applicable gift threshold, then the gift can become a taxable gift. If the gift is a taxable gift, and the debtor is insolvent, there is case law authority that the amount of the gift is limited to the amount by which the debtor becomes solvent Michael Best & Friedrich LLP 33

34 PARTNERSHIP DEBT SHIFT In a partnership, partners are treated as having tax basis equal to the amount of debt allocated to the partner. IRC 752. When partnership debt is forgiven, partners can find the debt that previously supported a negative capital account decreases or is shifted to other partners. This is treated as a distribution of cash. 752(b). If the 752(b) distribution exceeds the partner s tax basis in the partnership interest, taxable gain results Michael Best & Friedrich LLP 34

35 BRINGING IT ALL TOGETHER The above principals are highlighted by an example. Problem: ABC Partnership has been in business a number of years but recently suffered because of the economic downturn. Its primary asset is a manufacturing plant where it brews world-class beer. Despite the interest of consumers in drowning their sorrows, the beer is not selling. The manufacturing facility has a tax basis of $1 million, a fair market value of $2 million and is subject to debt of $4 million. ABC has four equal general partners, Big Jim Potbelly Walker, Donald Big Hair Developer, Water Street Brewers, LLC, and Noseeum, Inc Michael Best & Friedrich LLP 35

36 Big Jim Potbelly Walker is a successful and wealthy individual with a net worth in excess of $50 million (i.e., he is hopelessly solvent ). Donald Big Hair Developer is a real estate developer who finds himself a bit over-extended as a result of the downturn in the real estate market. He has personal liabilities for debts in excess of $50 million and his projects are underwater by $15 million. Being a developer he is confident things will turn around soon and he will be fine. Water Street Brewers, LLC is a family-limited liability company. Not much is known about the profiles of the individual members but it is believed that there are over 10 individual members all related to the founder of the century-old brewery. Noseeum, Inc. is an S corporation that was carrying an active business of a brewery, where the brewery business was contributed to ABC Partnership. Noseeum now has its partnership interest in ABC Partnership and about $200,000 of cash that it is ready to distribute to its sole shareholder Michael Best & Friedrich LLP 36

37 ABC Partnership asks you if you can represent ABC Partnership in negotiating a workout with its creditors and/or a possible bankruptcy. ABC Partnership is interested in avoiding undesirable tax consequences for its partners Michael Best & Friedrich LLP 37

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