Will restructuring or modifying my business debt create taxable cancellation of debt income?

It can. The IRS says most cancelled debt is taxable income. In tax terms, the borrower reports cancellation of debt income unless an exclusion applies. There are three basic ways this can come up, which are forgiveness, settling for less, or restructuring.

Even small changes, such as revised interest rates or just extending the repayment period, can create taxable discharge of debt income. And there are other things that may not sound like debt transactions but that IRS might see as restructuring, such as using stock to pay off a loan or selling your publicly traded debt to someone you’re related to. So, what the IRS means by forgiveness, settling for less, and restructuring are things companies, especially highly leveraged companies that may be in debt extension mode now, should be aware of.

Interest rates have climbed faster than a lot of companies, especially start-ups and companies controlled by private equity or venture funds, can adjust. So, their owners have been talking to lenders. So there might be more debt restructuring cases in the coming months. That means you should understand this issue a bit.

A lot of people try to restructure on their own, at least at first. And if all you’re trying to get from the bank is waiving penalties, that’s usually not enough for them to want to restructure. So it’s more common for the borrower to try for full renegotiation. COD, and the IRS to whom it goes, have to be considered in any restructuring. If you can’t avoid treating your cancelled debt as income, make sure you work it into your other considerations for whether the new deal is a good one

Discharged debt is treated as taxable gross income, though there are some exceptions. The main ones involve bankruptcy and insolvency, but these must be calculated carefully. The IRS allows exclusion of canceled debt to the extent the firm is still insolvent (after the cancellation of debt). Also, if you qualify under those two, the reduction is applied against your net operating losses, tax credits, capital loss carryovers, and tax basis in certain property. Even if you can exclude cancellation of indebtedness income, much of it may just be deferred. In partnerships the rules apply at the partner level. ld expect a patchwork that doesn’t give every partner an equal outcome. How you r

That said, if you are facing credit issues at the moment, it’s far likelier that a restructuring of the loan will end up creating cancellation of indebtedness income.

What’s Called Forbearance

Most business owners who need to negotiate terms with a lender try to buy time, in the form of what’s called forbearance. That means persuading the bank not to demand payment for a while. As far as the IRS is concerned, most forbearance periods do not trigger recognition of COD income. Though there’s a decent amount of forbearance flexibility with loans, if you are a company in need of real credit relief, you are probably looking at something that changes more than just the timing of repayment.

Forbearance can be tricky if the lender defers interest and/or principal for a while. The IRS may call that a significant modification, which they can treat as a taxable exchange of the loan for a new, “modified” one. The IRS weighs all the facts and circumstances, in significant mod cases. If the facts favor you the transaction can still pass, but using the safe harbors guarantees there’s no cancellation of indebtedness income.

Make sure the safe harbors are met. Every deferred payment must be caught up within a window that starts on the original due date of the first deferred payment, and lasts the shorter of (1) 5 years or (2) 50% of the original loan term.

Under the rules, if all deferral is made up inside the right timing window, the changes to the note won’t be counted as a significant modification.

But longer extensions may also still escape tax if other factors favor you. A material deferral is generally treated as significant, though. The regulations provide some guideposts for all this.

The IRS tests for whether there’s been a significant change in the debt instruments’ yield, when payments are due, who owes or who the loan’s secured by, the basic nature of the debt instrument, and how covenants are accounted for.

Beyond those specific tests, their ”catch-all test” is whether your legal rights and obligations changed in an economically significant way. The particulars of each case matter, so seek advice.

If the IRS says your debt has been significantly modified, then it will see it as the issuance of a new note in exchange for the old. So they’ll compare the adjusted issue price of the old loan to the issue price of the new loan. If the amount of the old loan is greater, they’ll treat the difference as a cancellation of indebtedness.

Whether Debt Is Traded or Privately Held

In the context of restructurings, whether debt is traded or privately held is important. You’re not always in position to tell who your debt holders are, and it isn’t always clear that your debt counts as publicly traded debt.

Basically, as of 2012, a loan counts as public if, during the 31-day period ending 15 days after issue, there’s either a sales price or a broker quoted price.

One escape is that debt of $100 million or less is treated as nonpublic. If your debt is traded, and its fair market value (FMV) has dropped by the time of the restructuring, COD income becomes more likely. The IRS treats these transactions as paying the old debt off with the new loan, so the reduced FMV of your new debt is the price at which you re-acquired your old debt.

There are two results from modifying traded debt: you’re more likely to have COD income, and the new loan can have original issue discount (OID) liability.

In a COD restructuring, IRS will look at what a note was trading at just before the new issue. The consequences of debt trading below its issue price at replacement time only affect publicly traded debt, since no other form is priced the same way.

A related party’s buying publicly traded debt at a discount can cause discharge of indebtedness income, and therefore tax. Sometimes private equity funds or owners will buy their portfolio company’s debt on the market. They must take into account potential COD issues.

Remember timing of this when filing returns: the COD income is taxable at the time of the exchange, while the OID deductions are spread over the life of the new loan. However, the interest deduction limits of the Tax Cuts and Jobs Act can cut into those new deductions. And that provision can hit highly leveraged companies very hard.

Say a company has $100,000 of publicly traded debt now worth $90,000 due to the coronavirus downturn. The bank is willing to defer interest payments for two years. If that’s a significant modification, you’ll have $10,000 of COD income. The $10,000 OID deduction can spread over the new term, but you still must report COD this year.

Ordinary Income

Any cancellation of indebtedness income (COD) is ordinary income. There’s no argument. And that’s a big deal if you’re a pass-through entity taxed as individuals, who pay ordinary income rates, not capital gains. Refinancing doesn’t solve the issue, the IRS treats the canceled debt as income even though it’s replaced with a new loan. As income, it could put you into a higher tax bracket, and it’s payable for the tax year the debt is restructured. The worst part is, you still need to service your loan, even though your tax bill is higher.

Among the special rules affecting restructurings, you can’t overlook that unutilized net operating losses can offset a lot of extra tax hit from cancellation of indebtedness income. Federal NOLs may be of limited benefit right now, as they have to be set against 80% of this year’s taxable income. But NOLs still have federal value, as they can be carried forward indefinitely. States, such as Connecticut and Rhode Island, have extended carryforwards of NOLs. It’s not always easy, and it may hurt to give those up.

The bottom line in this is that, when companies are negotiating to restructure credit arrangements, cancellation of indebtedness income taxes should be an issue from the outset. If the bank negotiates with you, get a tax expert involved early. That way you can structure the changes to limit exposure and plan for tax payments.