Companies facing Chapter 11 bankruptcy or needing to reorganize their capital structure because of their debt should consider the potential advantages offered by a taxable sale of the debtor’s assets in a “Bruno’s Transaction.”
While a tax-free reorganization may itself offer many benefits, there are circumstances when a taxable sale of the debtor’s assets to the creditors may be more beneficial. This kind of transaction is referred to as a “Bruno’s Transaction” when structured similarly to the transaction entered into by Bruno’s Inc., a supermarket chain, upon its emergence from bankruptcy. In 2003, the IRS issued a Chief Counsel Advice (CCA 200350016), which concluded that a Bruno’s Transaction was not a tax-free reorganization, and thus, was a taxable sale of the debtor’s assets to its creditors. In the right situation, this type of transaction may offer the purchaser of the assets a valuable step up in basis while the income to the debtor can be offset with tax attributes like losses or suspended deductions.
The transactions in Bruno’s and the CCA were both effectuated within a Chapter 11 proceeding. However, it may be possible for taxpayers to achieve similar results through an out-of-court debt workout. Taxpayers should evaluate the benefits and viability of a Bruno’s Transaction, or a similar transaction, even when creditors will obtain stock in an out-of-court debt workout.
In the CCA, Corporation A and its subsidiaries had filed a voluntary petition under Chapter 11. The plan of reorganization provided that Corporation B would be formed by Corporation A followed by a series of transactions including: 1) Corporation A selling some of its assets to Corporation B, 2) Corporation A transferring some assets to the creditors in cancellation of their claims, 3) the creditors contributing such assets to Corporation B, 4) the existing stock of Corporation A being cancelled and Corporation A issuing new stock to the creditors and 5) Corporation B issuing stock and notes to the creditors.
The IRS concluded that the transaction described in the CCA did not qualify as a tax-free reorganization. It found that the transaction did not meet the requirements of a tax-free “G Reorganization” under Section 368(a)(1)(G) primarily because the creditors that received the stock in Corporation B were neither prior stockholders nor prior security holders of Corporation A. Therefore, Corporation A was treated as having sold assets to Corporation B and the creditors, resulting in Corporation B obtaining a basis in the acquired assets equal to their fair market value. The IRS also viewed the fact that Corporation A did not liquidate as important.
Since the CCA was issued, Bruno’s Transactions have become a structuring option under the right circumstances. While there may be many structuring considerations for both tax and non-tax reasons, some of the key federal income tax considerations for a Bruno’s Transaction are discussed below. There may also be viable alternatives other than the specific transaction described in the CCA to achieve the same or similar results for tax purposes (e.g., a transaction involving an election under Section 336(e)).
There can be significant tax benefits for the debtor to structure its emergence as a Bruno’s Transaction, but only in the right set of circumstances. The following considerations may affect the extent that a Bruno’s Transaction would be beneficial to the debtor and the emerging company.
Step-up in tax basis
If the aggregate fair market value of the debtor’s assets exceeds its tax basis, there is potential for a step-up in tax basis of the debtor’s assets for the purchaser. This allows a potential benefit for the purchaser as the result of a fully taxable sale compared to a tax-free reorganization. In some situations, a Bruno’s Transaction will give a restructured company the opportunity to exit bankruptcy with increased future deductions for depreciation and amortization compared to a tax-free reorganization. Some asset purchases may even qualify for immediate expensing, thus creating a significant tax benefit immediately.
Sufficient tax attributes to offset a tax gain
Because a Bruno’s Transaction results in a taxable sale of the debtor’s assets, the debtor may have taxable income to the extent there is built-in gain in the transferred assets. However, a taxpayer may be indifferent to gain on the sale of assets if the taxpayer has a sufficient amount of tax attributes (e.g., net operating losses (NOLs), capital losses, Section 163(j) interest expense carryforwards) to offset such gains.
The debtor may have cancellation of indebtedness (COD) income as a result of undertaking an out-of-court workout or emerging from Chapter 11 regardless whether the transaction is taxable or tax-free. If the debtor is insolvent prior to the restructuring or in Chapter 11, any COD income is generally excluded from taxable income under Section 108. However, any amount excluded from taxable income under Section 108 must be applied to reduce the tax attributes (e.g., NOLs, tax basis in property) of the debtor. The amount and extent of such attribute reduction under Section 108 may vary depending on the final organizational structure, so it is important to analyze the impact of COD income for any structuring alternative.
In some alternatives, a debtor may exit bankruptcy with a lot of NOLs and other tax attributes, but Section 382 and other provisions might limit their usefulness. If Section 382 disallows the use of tax attributes, the company might end up with a large tax bill immediately after exiting — a terrible result for a company just reorganizing its capital structure or emerging from Chapter 11.
Before determining the structure of a plan of reorganization, it is imperative that a debtor considers its business needs and the income tax ramifications of its structure. With careful planning and modeling, a debtor may be able to perform a debt workout or emerge from Chapter 11 in a substantially better tax position than expected.
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Russell A. Daniel
Russell A. Daniel is a partner in the Tax Services practice in Charlotte, and leads the Mid-South market territory’s Tax Services practice. He assists clients in identifying and evaluating tax risks and opportunities in connection with transactions, including M&A, and implementing federal tax planning strategies.
Charlotte, North Carolina
- Strategic federal tax
- Tax reporting and advisory
Barry Grandon is a managing director in the M&A Tax Services group in New York. Grandon has more than 20 years of comprehensive experience in identifying and addressing tax issues and opportunities in a transaction-based environment.
- Technology and telecommunications
- Transportation, logistics, warehousing and distribution
- Retail and consumer products
- Strategic federal tax
- International tax
- Mergers and acquisitions
- Restructuring and turnaround
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