Business Bankruptcy–Tax Implications
Business Bankruptcy – Simplified Operating Guidelines
A "How-To" Manual
For Non-Bankruptcy Professionals
Robert S. Apfelberg, Karrie L. Bercik, Esq.
Chapter 10. Tax Implications
Chapter 11 cases usually raise tax issues. Bankruptcy inherently involves modification or cancellation of debt and transferring of assets. These actions frequently cause tax consequences for the debtor.
A. Cancellation of Debt
Major tax planning issues in bankruptcy are: (i) to minimize recognition of income from cancellation of indebtedness, and (ii) to maximize the use of tax attributes, such as net operating losses ("NOLs") and basis, after the bankruptcy. Cancellation or modification of indebtedness usually produces income equal to the amount of the debt cancelled or forgiven ("COD income"). The timing of the debt discharge and COD income is usually the effective date of the plan. COD income may also be realized even if the debt is not actually cancelled. The following events may cause COD income:
(a) If a debtor replaces an existing debt with new debt;
(b) If the terms of an existing debt are materially modified in kind or extent (perhaps by a cram down);
(c) If a person related to the debtor acquires the debt at a discount from a person unrelated to the debtor; or
(d) If a debtor that is a corporation issues stock in exchange for the debt (perhaps by a "creditors plan").
COD income of taxpayers is excluded from income under Internal Revenue Code ("IRC") §108 ("bankruptcy exception"). Bankrupt taxpayers are those entities or individuals under the jurisdiction of the court where the discharge of indebtedness is either granted by the Court or pursuant to a plan approved by the court. A taxpayer who excludes COD income from currently taxable gross income due to the bankruptcy exception is required to reduce tax attributes by the amount of the excluded income. This reduction is done in the following order of priority:
(a) net operating losses and net operating loss carryovers;
(b) general business credits under section 38;
(c) alternative minimum tax credits;
(d) net capital losses and capital loss carryovers;
(e) the basis of depreciable property (to the extent the basis exceeds remaining liabilities);
(f) passive activity losses and credit carryovers; and
- foreign tax credits and carryovers.
The bankruptcy exception is also helpful since the reduction in attributes occurs after the calculation of tax for the year of the discharge. Thus, the debtor may be able to use its NOL to offset current income before the NOL is reduced by the bankruptcy exception. Attributes are reduced dollar-for-dollar, except for tax credits, which are reduced 33-1/3 cents for each dollar.
A taxpayer may instead elect to first reduce the basis of depreciable property. This reduction in basis is limited to the taxpayer’s adjusted basis of depreciable property held at the beginning of the taxable year following the taxable year in which the debt is cancelled (effective date of the plan).
B. Asset Transfers
Often assets are sold or transferred as part of the plan. These transfers may cause the debtor to recognize gain or loss on the disposition under IRC §1001 unless some other IRC provision (bankruptcy exception) excuses the recognition of the gain or loss. The gain is measured by the difference between the amount paid by the purchaser and the basis the debtor has for tax purposes in the property.
Sometimes the property may be transferred back to a secured creditor by allowing the secured creditor to retake possession of the property in partial satisfaction of that creditor’s debt. The transfer is treated as a sale of the property even though the debtor does not receive any cash. The purchase price for tax purposes will depend upon whether the debt securing the property is recourse or nonrecourse.
If the debt is nonrecourse, the purchase price will be the total debt securing the property at the time of the transfer. Thus, if property subject to a nonrecourse debt is transferred to the secured creditor, the debtor will recognize gain or loss equal to the difference between the amount of the debt discharged and the debtor’s adjusted tax basis in the property immediately before the transfer. However, no portion of the debtor’s gain is treated as COD income and the property’s fair market value is irrelevant to the transaction.
If the debt is recourse the transaction is split into two parts consisting of: (i) a taxable disposition of the property, and (ii) to the extent the value of the property is less than the recourse liability, either a continuing debt obligation to the creditor or a discharge of the remainder of the liability. Under this approach, the taxpayer recognizes gain or loss equal to the difference between the fair market value of the property and the taxpayer’s adjusted tax basis therein immediately prior to the transfer. If the remainder of the debt is forgiven, the amount forgiven will constitute COD income that, unless excepted under the bankruptcy exception, will be included in the taxpayer’s ordinary taxable gross income.
C. Net Operating Losses and Other Considerations
There are numerous other tax considerations that may arise in a chapter 11. These issues are too numerous and specific for this article. However, as a general rule, anytime a corporation has a NOL carry forward, any transfer of the corporation’s stock may endanger whether the NOL may still be used. A sale of the assets, only, will not allow the purchaser to use any portion of the seller’s NOL. These same rules are applicable to debtor corporations sale of stock or assets.
Any transfer of assets into or out of the debtor must be scrutinized under the general partnership and corporate tax laws to determine the tax effect of the transfer. Any payments to insiders, owners, or employees must also be scrutinized to determine the tax consequence to the debtor.
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