Whether it’s due to the current economic environment or other challenges, businesses may increasingly find they are no longer able to service their debt and will need to restructure their capital. Businesses must weigh several factors when deciding whether to restructure the debt in bankruptcy or out-of-court, including cost, timing and risk to ongoing business.
What may be surprising to learn is that this decision could also significantly impact current and future after-tax cash flows. This article will explore the primary tax considerations in choosing between the two paths.
A debtor may realize cancellation of debt income (CODI) when it restructures its debt, whether it is settled with cash and property, equity of debtor and/or new debt. As discussed in a prior story on the impacts of debt modifications, CODI may even arise when debt is restructured with more favorable terms (e.g., reduction in interest rate, extension of maturity date, etc.). It isn’t necessary for the principal on the debt to be reduced to trigger CODI. When CODI is triggered, it is generally taxable income – unless exclusions discussed below apply.
Without an exclusion from taxable income, a corporation generally uses its tax attributes (e.g., net operating losses (NOLs), deferred interest deductions, credit carryforwards, etc.) to offset the CODI within the current year taxable income calculation. To the extent the debtor lacks enough attributes to offset the CODI, the corporation may owe taxes as a result of restructuring its debt. Also, following the Tax Cuts and Jobs Act (TCJA), new NOLs can only offset 80% of taxable income in some years, so the corporation might still end up owing tax on its CODI even with plenty of NOLs and credits otherwise available. To compound the problem, if a corporate debtor uses its equity to settle the debt, Section 382 (as discussed below) may limit the corporation’s ability to utilize its net operating losses and other tax attributes to offset the income following the exchange.
To alleviate the immediate burden on distressed companies, the tax code allows corporations to exclude some or all CODI from taxable income depending on how their debt is being restructured. In a bankruptcy, a corporation can generally exclude all the CODI from taxable income. In an out-of-court debt restructuring, however, a corporation can only exclude CODI to the extent the corporate debtor was insolvent immediately prior to the debt restructuring. Thus, a bankruptcy proceeding may be advantageous if the taxpayer is not substantially insolvent and/or has limited NOLs to offset any taxable CODI.
A partner in a partnership may only exclude partnership CODI from taxable income to the extent the partner (not the partnership) is in bankruptcy and/or insolvent. This creates substantial pressure on the partnership to determine not only the amount of CODI but also how it is allocated among the partners.
Grant Thornton Insight: Bankruptcy allows unlimited exclusion from taxable income from CODI, even when the taxpayer is made solvent.
The exclusion of CODI from taxable income in the case of bankruptcy and insolvency does come at a cost. The tax code requires a corporation to reduce its tax attributes to the extent it excludes CODI from taxable income. Tax attributes eligible for reduction include NOL carryforwards, credit carryforwards and basis in property (including basis in stock of subsidiaries and intercompany accounts). The amount and type of tax attribute reduction depends on numerous factors, including certain tax elections available to the corporation. The tax attribute reduction rules are further complicated if the corporation is a member of a group that files a consolidated federal income tax return.
The tax attribute reduction rules operate similarly whether the corporation is in bankruptcy or out-of-court debt restructuring. However, depending on the specific circumstances of a corporation, one may be preferential to the other. It is therefore important that the debtor assesses the impact to its tax attributes before the debt is restructured and pursues any available path to maximize its future after-tax cash flows.
Grant Thornton Insight: Neither a bankruptcy nor an out-of-court debt restructuring is obviously more advantageous. Both scenarios result in attribute reduction, although one may be preferable depending on the case.
Section 382 limits a corporation’s ability to utilize its net operating losses, credit carryovers and certain other tax attributes following a significant change to the corporation’s ownership. The limitation is based on the corporation’s equity value immediately before the change multiplied by a tax-exempt rate of return (currently less than 1%). If the corporation has certain built-in gains or losses in its assets as of the date of ownership change, the limitation may be increased or decreased respectively. In a debt restructuring (whether in bankruptcy or out-of-court), the creditor may take a significant stake in the corporate debtor and trigger an ownership change under Section 382.
In bankruptcy, corporate debtors are afforded special rules that may limit the impact of Section 382 and provide several options for preserving tax losses for use after the debt workout. If certain conditions are met, Section 382(l)(5) allows a corporation in bankruptcy to treat its former creditors as shareholders for purposes of determining whether an ownership change occurred. This has the advantage of avoiding an ownership change (and potentially permanently avoiding the limitation under Section 382), but it comes at the cost of reducing the pre-change losses for interest expense to those former creditors in the prior three years. However, this loss of historic interest deductions is less of a concern in the post-TCJA world, as many companies may already have significant deferred interest deductions under Section 163(j) that tend to be eroded through operation of this rule. In addition, if the corporation has another ownership change in two years, the Section 382 limitation becomes zero and all attributes become worthless. It is important to plan for this holding period issue on the part of the new owners.
If the conditions of Section 382(l)(5) are not met, or if the debtor elects out of its application, Section 382(l)(6) allows a corporate debtor in bankruptcy to increase its pre-change value by the amount of the debt cancelled in the restructuring. This can be advantageous if the corporation is insolvent prior to the bankruptcy but extinguishes enough debt in the bankruptcy to be solvent when it emerges.
In an out-of-court debt restructuring, Sections 382(l)(5) and (6) do not apply. Thus, if a corporation is insolvent prior to an out-of-court debt restructuring that triggers an ownership change, the corporation will only be able to utilize its net operating losses and credit carryovers to the extent it has substantial built-in gain in its assets.
Grant Thornton Insight: Bankruptcy clearly provides the most options for preserving tax losses for use after the debt workout.
Debtors generally incur significant expenses in a debt restructuring, whether in or out of bankruptcy. Bankruptcy tends to be more expensive than an out-of-court workout, which is an economic reason that companies prefer to avoid bankruptcy when possible. The tax deductibility of the costs of each varies slightly. If the debtor files for bankruptcy, professional fees are typically nondeductible to the extent the fees are paid to institute or administer the Chapter 11 proceeding. Amounts paid to formulate, analyze, consent or obtain approval of the portion of a plan of reorganization under Chapter 11 that resolves tort liabilities, however, may be deductible.
In an out-of-court workout, whether the fees incurred in a debt restructuring are deductible, is dependent on several factors, including the form of the debt restructuring. Before finalizing its plan, the debtor should consider the impact to the deductibility of transaction costs as this may reduce after-tax cash flows following emergence. Thus, an out-of-court workout may be advantageous in that the debtor may be able to deduct more of the fees incurred in the restructuring (and the overall costs are generally significantly less than in a bankruptcy).
Grant Thornton Insight: An out-of-court workout may reduce costs and allow the taxpayer more deductions.
It is not unusual for a distressed company to have historic exposures related to tax liabilities, such as sales and use taxes and unfiled state income tax returns. In a bankruptcy, the debtor must typically report their current tax liabilities, including liabilities to states for income and non-income taxes, to the court. The bankruptcy process may allow the debtor to cancel these tax liabilities. A company in an out-of-court workout, however, is typically not afforded the same process and will retain historic tax liabilities. Thus, a bankruptcy may be advantageous if it allows the company to cleanse itself of historic tax exposures and make itself more attractive to a potential future investor.
Grant Thornton Insight: Bankruptcy may offer a company a fresh start from past liabilities.
There are a number of alternatives a debtor may pursue in restructuring its debt which may significantly affect the debtor’s after-tax cash flow.
In a previous story on transaction structures, we discussed an alternative where the debtor transfers assets to its creditors in a taxable sale transaction (often called a “Bruno’s transaction” named after a southern supermarket chain that filed for bankruptcy). A Bruno’s transaction may be beneficial when a corporate debtor’s assets have substantial built-in gain and there is a risk the debtor would lose substantial attributes through tax attribute reduction. If implemented correctly, the creditor will get a stepped-up tax basis in the assets at the cost of losing the debtor’s carryover tax attributes (which would be limited by Section 382).
The cancellation of intercompany debt in a bankruptcy may significantly impact the amount and type of attribute reduction. Careful consideration of the cancellation of intercompany debt in attribute reduction is paramount to managing the after-tax cash flow of the corporate debtor. Additionally, for a variety of business purposes, it may be beneficial to create or eliminate an intercompany debt prior to emergence. The creation and/or cancellation of intercompany debt in a bankruptcy will likely need to be approved by the courts. This approval process in bankruptcy may add weight to the existence of these steps for tax purposes that may not be afforded if the debtor restructuring out-of-court.
Grant Thornton Insight: There are often alternatives for either a bankruptcy or an out-of-court debt workout. It is always prudent to consult a tax advisor for these transactions.
There are significant tax advantages and disadvantages when a corporation restructures in bankruptcy or out-of-court. It is important that the debtor models out the results of each of its options prior to consummating the plan. With proper planning, a corporation can maximize its after-tax cash flows following a debt restructuring.
To learn more visit gt.com/tax
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
- Corporate tax
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