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Current economic conditions are requiring many lenders and borrowers to restructure the terms of outstanding indebtedness. In many cases in which conditions do not force a restructuring, economic conditions have created an opportunity to restructure or acquire debt on favorable terms.

In contemplating any debt restructure, the income tax consequences to all parties must be carefully considered. If not properly structured, a debt workout can result in one or more of the parties being taxed on income without receiving any cash.

The American Recovery and Reinvestment Tax Act of 2009 (the 2009 Act), enacted on February 17, 2009, made temporary changes to the tax laws intended to ease the adverse tax consequences to debtors from debt reductions.

This Alert summarizes some of the significant income tax issues that should be considered by businesses and investors in connection with any debt restructuring, including the effects of the 2009 Act.

1. Debtor’s Cancellation of Debt Income. The most significant tax concern for the debtor in a restructuring is the potential for recognizing cancellation of debt income or CODI. As a general rule, if the outstanding amount of a debt obligation is reduced without being paid, the debtor is required to recognize ordinary income equal to the amount of the reduction. The resulting tax liability can be disastrous to the debtor since the transaction does not generate any cash for the debtor and the debtor is likely experiencing financial distress without regard to income taxes.

(a) Sources of CODI. CODI can arise in a number of circumstances involving the modification, exchange or satisfaction of debt. Common examples of transactions resulting in CODI include the following:

(i) Debt Cancellation or Reduction. If a debt is explicitly cancelled or the amount owing is reduced, the amount of the debt forgiven is CODI.

(ii) Debt Modification. If the terms of a debt are significantly modified, the debt before the modification is treated as exchanged for the modified debt. CODI will result if the issue price of the modified debt is less than the adjusted issue price of the debt before modification. Even if the stated principal amount of a debt is not changed, CODI results if the debt is modified such that its yield to maturity is less than the applicable federal rate (AFR) at the time of the modification.

Example: The terms of an existing debt of $1 million provide that interest is payable annually at 8 percent and the entire principal balance is payable at maturity. When the debt is five years from maturity, the debt is modified by reducing the interest rate to 1 percent. At the time of the modification, the AFR is 2 percent. The issue price of the modified debt instrument would be approximately $952,865 (the present value of all amounts payable under the modified instrument, discounted at the AFR). The issuer would immediately realize CODI of approximately $47,135. This same amount would be treated as interest expense of the issuer and interest income of the holder, accruing over the remaining five‑year term of the modified instrument.

(iii) Property Transfer. If property is transferred in satisfaction of debt, the debtor may realize CODI and/or gain or loss from the property transfer.

(A) Recourse Debt. If property is transferred in satisfaction of recourse debt (the creditor’s remedies are not limited to specific property), the debtor realizes CODI to the extent that the amount of debt retired exceeds the fair market value of the property transferred. The debtor also realizes gain if the fair market value of the property transferred exceeds its tax basis, or loss if the property’s tax basis exceeds its fair market value.

Example: If a debtor owes $500,000 under a recourse debt, and transfers property having a value of $400,000 and a tax basis of $200,000 to the creditor in full satisfaction of the debt, the debtor would realize $100,000 of CODI and $200,000 of gain from the disposition of the property. The CODI would be ordinary income, subject to the exceptions to CODI recognition described below. The gain from the property disposition would be capital gain or ordinary income, depending on the nature of the property. This gain would not be subject to the exceptions to CODI recognition.

(B) Nonrecourse Debt. If the property securing nonrecourse debt is transferred in satisfaction of the debt, the debtor does not realize CODI. The debtor realizes gain to the extent the amount of the debt discharged exceeds the tax basis of the property transferred, or loss to the extent the property’s tax basis exceeds the debt discharged.

Example: If a debtor owes $500,000 under a nonrecourse debt, and transfers property having a value of $400,000 and a tax basis of $200,000 to the creditor in full satisfaction of the debt, the debtor would not recognize any CODI but would recognize $300,000 of gain from the disposition of the property. The character of this gain would be capital gain or ordinary income, depending on the nature of the property. This gain would not be excludable under any of the exceptions to CODI recognition.

(iv) Equity Issued in Satisfaction of Debt. If a corporate debtor transfers its stock in exchange for its outstanding debt, the debtor realizes CODI only if and to the extent that the amount of debt discharged exceeds the fair market value of the stock issued. A similar rule applies if a partnership (or an LLC taxed as a partnership) issues a partnership interest in exchange for debt of the partnership.

(v) Acquisition by Related Party. If a person related to the debtor acquires debt from a person not related to the debtor, the debtor may realize CODI. The amount of CODI is measured by either the price paid by the related party for the debt or the debt’s fair market value, depending on the circumstances of the acquisition. Parties are generally considered related for this purpose if one party owns more than 50 percent of the other or if their common ownership exceeds 50 percent.

Example: If a debtor owes $500,000 under a debt instrument held by an unrelated party, and a person related to the debtor purchases the debt instrument from the unrelated party for $400,000, the debtor would realize CODI of $100,000.

(b) Taxation of CODI. If a debtor realizes CODI, the debtor is generally taxed on ordinary income in the amount of the CODI in the year in which the debt cancellation occurs. Recognizing that a transaction triggering CODI does not generate liquid assets for the debtor, the tax law contains a number of exceptions to the immediate taxation of CODI, including the following:

(i) Deferral under 2009 Act. The 2009 Act allows taxpayers to elect to recognize certain CODI ratably over five years, beginning five years after the CODI is realized for CODI realized in 2009 or beginning four years after the CODI is realized for CODI realized in 2010. This election not available for CODI realized before 2009 or after 2010.

― If a taxpayer elects to defer the recognition of CODI under this provision, then the statutory exclusions of CODI for bankruptcy, insolvency, and qualified real property business indebtedness do not apply to the discharge of that indebtedness for the current year or any subsequent year.

― Any deferred CODI must be recognized when the taxpayer dies, liquidates, sells substantially all of its assets or terminates its business. The same acceleration applies to a partner or S corporation shareholder that disposes of its interest in the entity with deferred CODI.

― It is not completely clear that the new deferral election is available for CODI arising from a transfer of property (other than cash, new debt or equity in the debtor) in satisfaction of debt. It is hoped that this will be clarified in the near future.

Planning Considerations under the 2009 Act: The CODI deferral under the 2009 Act is elective. Deciding whether to elect the deferral requires strategic planning, as the deferral may not be optimal in all cases. For example, a debtor that elects the deferral is precluded from excluding CODI from the same discharge under certain other exceptions. These exclusions may provide the debtor with a greater benefit, but may not be available with respect to the entire CODI amount.

Because the deferred CODI is accelerated upon the occurrence of certain events, such as a liquidation or asset sale, the debtor must estimate whether it will benefit from the maximum deferral period and, if not, the amount of actual deferral that is likely to occur. A debtor should also consider the availability of losses or credits to offset the CODI recognition in the deferral years and the possibility that different tax rates may apply in those years.

The strategic considerations are multiplied in the case of a debtor that is a partnership or an LLC taxed as a partnership. The deferral election must be made by the partnership, but the election may have different consequences for different partners. For example, a partner that is insolvent may prefer to forego the deferral election to take advantage of the exclusion of CODI from income for insolvent taxpayers. If the partnership elects the deferral, the deferral period may vary for different partners, since the deferred CODI must be recognized upon the occurrence of events at the partner level, such as the sale of an interest in the partnership.

The deferral of CODI may constitute a significant deferred tax liability. Equity acquirers should be aware of this potential deferred liability in conducting due diligence and in crafting representations and indemnities with respect to acquisitions of target companies.

(ii) Bankruptcy or Insolvency. CODI is not taxable if the discharge occurs in bankruptcy or to the extent that the debtor is insolvent immediately before the discharge. Insolvent means the debtor’s liabilities exceed the fair market value of its assets. The insolvency exclusion is available only to the extent that the debtor is insolvent before the discharge. A partner’s share of a partnership’s CODI is excluded from tax only if the partner is in bankruptcy or insolvent, regardless of whether the partnership is in bankruptcy or insolvent.

If CODI is excluded from income under the bankruptcy or insolvency exception, the debtor must reduce certain tax attributes, including loss carryovers and asset basis, but the CODI exclusion is not limited to the amount of attributes available for reduction.

Example: A debtor corporation has assets with an aggregate value of $400,000 and aggregate liabilities of $500,000. If all of the liabilities are discharged, the debtor corporation would realize CODI of $500,000. Under the insolvency exception, $100,000 of the CODI would be excluded from income and the remaining $400,000 would be recognized as ordinary income. If instead the discharge occurs when the corporation is in bankruptcy, none of the CODI would be taxable.

(iii) Qualified Real Property Business Indebtedness. For taxpayers other than C corporations, CODI is not taxable if it arises from a discharge or reduction of “qualified real property business indebtedness.” In general terms, qualified real property business indebtedness is debt incurred to acquire or substantially improve real property used in a business (excluding inventory-type property), and secured by that real property. The amount of CODI excluded from income is limited to the excess of the principal amount of the discharged debt over the fair market value of the real property immediately before the discharge. The excluded CODI may not exceed the debtor’s basis in depreciable real property, and the debtor must reduce its basis in depreciable real property by the amount of the excluded CODI.

Example: Assume that an individual debtor owns depreciable real property used in business that has a current value and tax basis of $300,000. The real property secures debt that constitutes qualified real property business indebtedness with a principal amount of $400,000. If the debt is completely forgiven, the debtor would realize $400,000 of CODI. The debtor could exclude $100,000 of CODI from income. The remaining $300,000 of CODI would be immediately taxable. The debtor’s basis in the property would be reduced to $200,000.

2. Other Tax Considerations for Debtors. In addition to the potential for CODI, there are often other significant tax effects for the debtor to consider, including:

(a) Property Gain or Loss. If property (other than cash or equity in the debtor) is transferred in satisfaction of debt, the debtor may recognize taxable gain or loss with respect to the transferred property, either in addition to or instead of CODI. Examples of transactions triggering this type of gain or loss are described above. While CODI is always ordinary income, the character of gain or loss arising from a property transfer will depend upon the nature and holding period of the property transferred. Note that the various exclusion and deferral options described above for CODI are not available for this gain.

(b) Original Issue Discount. Debt is often modified by reducing the rate at which interest accrues or the rate at which interest is currently payable (with additional interest accruing and payable on a deferred basis), which can result in original issue discount, or OID. If CODI results from an acquisition of debt by a person related to the debtor, the debt immediately before the acquisition is treated as satisfied by a new debt instrument with an issue price based on the amount used to determine the debtor’s CODI (the related party’s purchase price or the debt’s fair market value). Any excess of the new debt’s stated redemption price over its issue price (which in most cases will equal the debtor’s CODI) constitutes OID.

The debtor generally deducts the OID as interest expense as it accrues over the remaining term of the debt, even if the interest is not payable until a later period. If the recognition of CODI is deferred under the new rules in the 2009 Act, the deduction of OID arising from the same transaction must also be deferred.

(c) High-Yield Obligations. A corporate debtor’s interest deduction is limited if the debt instrument has a term of more than five years, a yield to maturity of at least the AFR plus 5 percent, and “significant OID.” These debts are referred to as applicable high yield discount obligations or AHYDOs. A portion of the OID on an AHYDO is treated as a non-deductible dividend and a portion may be deductible only when it is actually paid. Corporate debtors should be aware of the AHYDO rules in connection with any instrument that may have OID. The 2009 Act suspends these limitations for new debt obligations issued from September 1, 2008, through December 31, 2009, if the new obligation is issued in exchange for an obligation that is not an AHYDO and that has the same issuer or obligor as the new obligation.

3. Tax Considerations for Debt Holders. Debt holders must also carefully consider their tax consequences in a restructuring transaction. The most common tax concerns for debt holders include:

(a) Recognition of Gain or Loss. A restructuring often results in an economic loss to the debt holder because the debt holder is forced to accept less than the full amount of the debt. The amount of the debt holder’s tax loss, however, is measured by the debt holder’s tax basis for the debt immediately before the restructuring, rather than the face amount. If debt is cancelled, significantly modified or exchanged for a new debt instrument, the debt holder will realize a tax loss to the extent that the holder’s tax basis for the original debt exceeds the value (in the case of publicly treated debt) or issue price (if the debt is not publicly traded) of the new or modified debt.

If the debtor accepts cash or other property (including equity of the debtor) in exchange for the debt, the debt holder will realize a loss to the extent its basis for the debt exceeds the value of the cash and property received.

The holder may recognize a gain in connection with a modification or exchange of a debt instrument if the value or issue price of the new debt instrument exceeds the holder’s tax basis for the original debt instrument. Similarly, if a debt holder accepts cash or property in satisfaction of a debt, the holder would recognize gain if the amount of cash and the value of the property received exceeds its basis for the debt instrument. The debt holder’s tax basis for the debt may be less than the amount received if, for example, the holder purchased the debt at a discount or the holder has previously deducted all or part of the debt as a bad debt or a worthless security.

The character of the holder’s gain or loss depends on the nature of the debt instrument and the circumstances of the holder. For example, if the holder is a dealer of debt instruments in the nature of the restructured debt, any gain or loss would be ordinary income loss. If the holder holds the debt as an investment, the gain or loss would be a capital gain or loss. In any case, any gain attributable to accrued interest is recognized as ordinary interest income. If the debt was purchased at a discount from par, any gain recognized is ordinary interest income up to the accrued market discount.

(b) Recapitalizations. Under certain circumstances, if a corporate debtor issues new debt or stock in exchange for its outstanding debt, the exchange may qualify as a tax-free recapitalization. If the exchange is a recapitalization, then the holder does not recognize gain or loss in connection with the exchange, other than gain attributable to accrued interest.

(c) Acceleration of Installment Gain. If the restructured debt was received in an installment sale by the holder, an exchange of the debt for other property and certain modifications of the debt may accelerate the recognition of deferred gain from the installment sale.

(d) Original Issue Discount. As described above, restructuring a debt instrument often results in original issue discount. If the terms of a debt provide for the accrual of interest in excess of the amount of interest that must currently be paid, the holder is generally required to recognize the interest income as it accrues even if it is not paid until a later period. Similarly, if a person related to the debtor acquires a debt at a discount, the acquirer may be required to recognize the discount as OID interest accruing over the remaining debt term. If the interest accrual rate is reduced to less than the AFR at the time of the reduction, the tax law will impute interest on the obligation at up to the AFR, and the debt holder may be required to recognize interest income at this rate even if it exceeds the stated rate on the instrument.

In compliance with US Treasury Regulations, please be advised that any tax advice given herein was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax penalties or (ii) promoting, marketing or recommending to another person any transaction or matter addressed herein.