Got Debt? No one can predict how the U.S. economy will rebound from COVID-19. For many business owners and companies, the crisis has permanently challenged their financial stability. To stay viable in this “new normal,” restructuring of your balance sheet and debt obligations may be part of your post-pandemic strategy, but the tax implications of these actions should never be an afterthought. Restructuring debt may create a more sustainable business model, but remember that although doing so may make bills and obligations disappear, there may be unexpected tax implications.
A foreclosure of assets, an exchange of assets for debt, or a reduction of debt, almost always creates a taxable event which may have a negative impact on cash flow and liquidity. In a restructuring, tax liabilities are often passed to the owners of LLCs, partnerships, or individuals, depending on the entity’s makeup, so stakeholders must carefully consider where the tax liability goes. The legal structure of the business being restructured has a much bigger impact than many business owners realize.
Those looking to offload assets to save money and reduce debt shouldn’t assume taxes can be avoided if no cash is exchanged during a transaction. Any time income is created, a taxable event occurs, and any tax liability from these transactions falls directly to the business or to whichever entity is paying the taxes.
Cancellation of debt income from restructuring, whether in bankruptcy court or out-of-court, often results in excess debt being forgiven. The amount of that debt forgiveness can be viewed as taxable income. Cancellation of debt income is a double-edged sword. For instance, if a business has “COD” income, it can claim insolvency in order to address current tax obligations, but the company can still have significant tax liability due to the reduction of tax attributes. If COD income exceeds tax attributes, the excess can also reduce the tax basis in assets, resulting in lower deductions to offset future taxable income.
What Exactly Is a Tax Attribute?
Tax attribute refers to certain losses like net operating losses, capital losses, and passive activity loss, as well as tax credits, tax-loss carryforwards, and the adjusted basis of property that must be reduced because of the exclusion of debt cancellation from a taxpayer’s gross income. Tax attributes are adjusted when a taxpayer is insolvent or declares bankruptcy and must be reduced by the amount of canceled debt excluded from income. Other important points:
- The IRS does not require forgiven debt to be included as taxable gross income.
- Gains from discharged debt is not factored into taxable income.
- In exchange for favorable tax treatment, the insolvent or bankrupt taxpayer must forgo certain tax attribute benefits.
How Exactly Do Tax Attributes Work?
According to the cancelation of debt income rules, canceled debt will not be taxable if:
- The debt was discharged in bankruptcy
- The debt was less than $600
- The debtor is insolvent, with debts greater than assets, but only to the extent of the insolvency
- The canceled debt was a gift or an inheritance from a friend or relative
Individual and business taxpayers who are forgiven their debts due to insolvency or bankruptcy do not have to include the forgiven debt as part of their taxable gross income. However, the discharged debt translates to financial gain. Generally the IRS taxes most financial gains earned by individuals and businesses. But here the IRS exempts gains from forgiven debt from being factored into taxable income, providing a measure of relief for certain taxpayers who find themselves facing serious financial difficulties.
In a nutshell, the amount excluded from gross income is used to reduce certain tax attributes that would otherwise be available to offset future income. So when a debt is canceled, the taxpayer forfeits some tax attribute benefits in exchange for receiving favorable treatment relating to the bankruptcy. Taxpayers must reduce these seven tax attributes in the following order:
- Net operating loss from any business
- General business credit carryover
- Alternative minimum tax credit
- Capital loss
- The cost basis of property
- Passive activity loss
- Foreign tax credit carryover
You may be solving one problem but creating another. Before canceling debt and creating a restructured balance sheet or capital structure with lower interest costs, evaluate tax implications of that canceled debt. Even if the tax resulting from restructuring may not necessarily be a current obligation, it can have a significant impact on future cash flow. In fact, it can considerably reduce the tax attributes of the surviving entity, making tax payments going forward much higher than they would be otherwise.
Reach Out To Us: Remember the amount of debt forgiveness, from a tax standpoint, can be viewed as taxable income. Having a clear picture at the outset of a restructuring will help assure that taxable events are not created and position the company for a more favorable outcome. In order to have a complete picture, contact your Fuoco Group tax professionals early in the process to develop an appropriate plan at CPA@fuoco.com.
