What are the tax consequences of business debt restructuring or cancellation, and how to reduce them?

It’s a challenging time for business owners. Anyone who runs a business these days faces relentless pressures from all sides. For workers, the ability to work from home can be a great perk. Remote work, which helps some workers, still contributes to lonely, deathly-quiet downtowns and could cause headaches for commercial property owners. Battered businesses may restructure or win debt forgiveness, but there will be tax questions along the way.

Debt Discharge Income

Cancelation-of-debt (COD) income can arise even if debt isn’t formally forgiven. That includes foreclosures, big loan modifications, owners contributing debt to capital, paying a debt in stock or partnership interest, or selling the debt to a related party. And since debt forgiveness produces no cash income, it can pop up without you having received any actual cash. Still, it’s taxable income.

Fortunately you can often defer some or all the tax hit by reducing certain tax attributes like net operating loss carryforwards, or your basis in the business’s assets. There are two places attributes can be cut: at the business or at the owners’, depending on how the business is structured. Under the right circumstances, you can buy time to marshal your financial resources. Note, though, that deferral is not elimination.

Recourse-debt foreclosure may split into a COD income component plus a gain or loss. To figure out the tax hit, you need to know the loan balance, what the foreclosed property was worth in a hypothetical sale, and how to determine your adjusted basis. Only the COD component is deferrable, not the gain or loss.

Nonrecourse-debt foreclosure is treated as if the foreclosed property was sold. There’s no COD income, and gains or losses are recognized in the year of the foreclosure.

Beyond loan forgiveness, loan modifications can produce COD income if the lender gets back less than the old loan balance. A significant loan modification is deemed an exchange, where the borrower pays off the old debt with the issue price of the new debt. If the new issue price is at least the old outstanding balance, there’s no COD income. If the new debt’s issue price is below the old debt’s balance, you have COD income in the year of the exchange.

A note or term loan is modified when the lender’s rights or the borrower’s obligations change under the loan agreement. Generally, a modification is deemed “significant” if the changes are economically significant, taking into account all facts and circumstances.

The tax regulations also lay out specific tests you must check to decide if a modification is significant. Any single test finding a significant change makes a change significant.

The first test is “yield.” A change is significant if the old loan and new loan’s annual yield varies by 25 basis points or 5% of the old loan’s yield.

Payment-timing changes that materially defer scheduled payments count as significant modifications.

Swapping a new obligor on recourse debt is generally seen as significant. So is a collateral swap-in or -out that alters payment expectations.

Switching from recourse debt to nonrecourse debt, or the reverse, almost always means a significant loan modification.

You’re deeply invested in your business, and chances are you wouldn’t hesitate to extend it a lifeline in tough times. Owners frequently lend to businesses under their own control instead of putting in more capital. It makes sense, but it can cause tax problems.

Converting a loan from a partner to a partnership interest may seem a simple transaction that produces no tax consequences, but that’s not always the case. The critical question is whether the market value of the partnership interest is lower than the loan balance you exchanged for it. COD income can crop up when shareholders convert shareholder loans to corporation stock.

A shareholder’s contributing a corporation’s debt to its capital generally entails a deemed payment of cash equal to the shareholder’s basis in the debt. This usually means no COD income. An exception arises when a cash-method shareholder waives interest an accrual-method corporation accrued but never paid, which can create COD income. A debt-for-capital swap might count as an ownership change. That can limit losses and credits from before the change.

If a related party buys the debt, the debtor is treated as buying back their own debt, producing debt discharge income. The same rule also covers people expecting to become related.

The good news is, there’s relief. Section 108 of the Internal Revenue Code gives several ways to keep cancellation-of-debt income out of this year’s taxable income. One important exception is the bankruptcy exclusion. You qualify if you’re under a court order discharging the debt in a Title 11 case. The insolvency exclusion requires total liabilities to exceed the fair market value of all assets, and only allows you to exclude COD income up to that amount. Qualified Real Property Business Indebtedness (QRPBI), meaning debt tied to real property used in trade or business, is different: QRPBI exclusions can be used by solvent and nonbankrupt businesses.

All the available exclusions work by deferring recognition of the COD income. They don’t forgive it. They push off any tax due, but that cost can reappear down the road. As the law requires, the exclusions cut your tax attributes to pay the cost of excluding the income from this year. Attributes are generally sliced in a fixed order:

• First, current-year NOLs or NOL carryforwards.
• Then general business credit.
• Then the minimum tax credit.
• Then capital losses and carryforwards.
• Then basis in property (own ordering rules; election to cut depreciable basis first).
• Then passive losses and credits.
• Last, foreign tax credit carryforwards.

Timing: attributes are reduced after computing the current year’s tax. Most tax attributes fall by a dollar for each dollar of COD income excluded from the current year. Credits sink 33 1/3 cents for every excluded dollar.

Who Gets the Benefit of Exclusions

Does your business structure matter? Quite a bit. It helps determine who gets the benefit of exclusions, but it also decides where tax attributes drop. C corporations can get the insolvency and bankruptcy exclusion at the corporate level. They also get the tax-attributes cut there. Owners won’t be directly affected, at least not in this year. For S corporations, these exclusions and attribute cuts happen at the entity level. COD income that’s excluded does not get passed through to an owner’s return, and results in no increase in stock basis. S corporation COD income that isn’t excluded passes to shareholders, increasing their stock basis. COD income might also release previously suspended shareholder losses. Partnerships pass debt discharge along to the owners, who apply these rules.

It makes perfect sense to hang on to your business through all kinds of trouble, but sometimes it’s not easy to sort through all the tax consequences. Beyond these rules, more complex planning may be possible, depending on each business’s particular facts.

Tragically, more of these situations are on the horizon. COD income isn’t something you might expect right now, but many businesses could find it staring them in the face. Knowing what triggers it and how to soften its impact is complex. No one wants a tax surprise. Understanding the rules can help you avoid tax and planning surprises when working to restructure your business’s debt obligations.