Be Aware of Tax Consequences Before Restructuring Debt

Amidst economic difficulties, many manufacturers take steps to reduce or restructure debt loads.

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Sometimes, that debt modification involves renegotiating loan terms with a bank or other financial institution. In other instances, a company may seek additional owners or partners.

Specific circumstances and needs vary from one company to another, but any manufacturer planning to restructure debt needs to be aware of possible adverse tax ramifications. Those ramifications center upon debt discharge income, the company's solvency status before and after the debt modification, tax elections, and the relationship between transfers in equity ownership and any net operating loss (NOL) tax attribute.

The amount of money a company saves through debt restructuring is regarded as debt discharge income. If a manufacturer, for example, owed $500,000, and was able to reduce that debt to $450,000, that $50,000 would generally be regarded as debt discharge income. Whether or not a company is solvent before and after the debt restructuring is the first step in determining tax treatment. Determining solvency involves comparing fair market value of assets to outstanding debt immediately before the discharge occurs.

Once those determinations are made and the debt modification is completed, the company will face decisions regarding which tax attributes must be reduced. Tax attributes are various factors that affect taxable income, including capital losses, various tax credits or net operating loss (NOL).

A company that is solvent at the time it initiated a debt modification in 2009 or 2010 may want to consider Section 108(i) of the Internal Revenue Code (IRC). That provision was included in the American Recovery and Reinvestment Act of 2009 (ARRA), and allows a company to defer recognition of debt discharge income from the 2009 or 2010 calendar years. The deferred recognition span for 2009 and 2010 debt discharge income is five years beginning in 2014. Another option available is for the taxpayer to elect under IRC Section 1018 to reduce its basis of depreciable assets. The effect will be to avoid immediate income recognition, but reduce future depreciation deductions.

If a company is insolvent or in Chapter 11 bankruptcy at the time of the modification, it can exclude some or all of the debt discharge income from being regarded as gross income. To claim such exclusion, though, the company must elect to correspondingly reduce various tax attributes that would otherwise lower its taxable income. If a company is insolvent at the time of modification but solvent afterward, the difference between assets and liabilities is also considered gross income.

Impact of new investors

In addition to such tax consequences, a company needs to consider how taking on additional investors may affect its ability to offset future taxable income with a current NOL. Under IRC Section 382, if more than 50 percent of a company's equity is transferred over a three-year period, the company is regarding as being under the control of new ownership. Such control transfers may result from numerous sources, such as convertible debt, stock options or injection of new equity from private investors such as venture capitalist or private equity firm investments. Equity transfers may be counted even though not completed if resulting from other events as well, including the use of stock warrants, puts, stock options or debt guarantees.

Debt restructuring may be necessary to survive prolonged economic difficulties, but companies need to be aware of the tax consequences that follow such modifications.

Mark D. Walker, CPA, mark.walker@weaverllp.com, is a partner in Tax and Strategic Business Services, and director of Inventory-Based Business Services at independent public certified accounting firm Weaver, with offices in Austin, Dallas, Fort Worth, Houston, Midland, Odessa and San Antonio.

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