Businesses still struggle with the right mix of debt and equity to stay afloat in this economy. Where cash-flow problems cannot be resolved by equity infusions or simple refinances, debt workout options include loan modifications, partial or full loan forgiveness, foreclosures or repossessions, and debt-for-equity exchanges.
“Debt workouts are painful enough without worrying about the IRS,” says Josh N. Wheeler, CPA, at Crowe Horwath LLP. “Business owners should consult with their tax adviser when contemplating a course or a combination of courses.”
Smart Business spoke with Wheeler and Catherine Fox-Simpson, CPA, a partner with Crowe Horwath LLP, about what taxpayers need to know when restructuring debt.
How are debt workouts taxed?
The Internal Revenue Code explicitly includes cancellation of debt (COD) income as a component of gross income. Even though a taxpayer has not received cash or property in such instance, he or she has relief from a financial burden. Of course, the Treasury wants a cut of the action.
Foreclosures, deeds in lieu of foreclosure, repossessions and abandonments are taxable sales or exchanges of property. In all these cases, gain or loss is the difference between the amount realized and the adjusted basis of the property. Be aware, the amount realized depends on whether the debt is recourse or nonrecourse.
Taxpayers in an entity taxed as a partnership have another aspect of debt cancellation to worry about. In cases where partners do not share debt allocations proportionately to income allocations, capital gains may result for a partner whose net debt relief exceeds his or her basis in the entity.
Debt-for-equity exchanges may also result in COD income when the fair market value of company stock or partnership interest exchanged is less than the debt balance forgiven. In most cases, fair market value will not conveniently equal the balance forgiven. Prudent business leaders hire qualified appraisers to perform business valuations or asset appraisals.
When is COD income excludable from gross income?
There are a few instances when taxpayers may elect to exclude COD income from gross income. The following list includes times of financial hardship and types of debt.
- Qualified farm indebtedness
- Qualified real property business indebtedness
- Qualified principal residence indebtedness
Income from a discharge of debt granted by a court or pursuant to a plan approved by a court in a bankruptcy (title 11) case, where the taxpayer is under jurisdiction of the court, qualifies for exclusion from gross income.
Income from a discharge of debt while a taxpayer is insolvent qualifies for exclusion, but only to the extent of insolvency. The Internal Revenue Code defines insolvency as the excess of liabilities over the fair market value of assets immediately before the discharge. This assessment measures debt differently depending on whether the debt is recourse or nonrecourse.
Income resulting from discharge of indebtedness incurred with respect to farming activities qualifies for exclusion from gross income only if fifty percent or more of the entity’s gross receipts relate to farming for the three years prior to the year of discharge.
Income from discharge of indebtedness assumed or incurred prior to January 1, 1993 with respect to real property used in a trade or business qualifies for exclusion from gross income. COD income subsequent to the aforementioned date must relate to the acquisition, construction, or substantial improvement of real business property in order to qualify.
Lastly, income from a discharge of acquisition indebtedness secured by a taxpayer’s primary residence may qualify for exclusion from gross income up to $2,000,000. Taxpayers who elect to exclude income under this provision must reduce the property basis accordingly. This break does not apply to discharges occurring later than December 31, 2012.
Taxpayers who are neither bankrupt nor insolvent and who do not have the above qualified debts may still take advantage of purchase price adjustments under purchase money debt reductions. When the original seller agrees to reduce debt secured by property of the original purchaser, the reduction in debt may apply to the adjusted basis of secured property. In this scenario, the adjustment does not result in taxable income.
What tax attributes must be adjusted?
A lender may forgive debt, but the IRS won’t forget. Bankrupt or insolvent taxpayers and taxpayers with discharged qualified farm indebtedness who benefit from COD income exclusion rules must adjust certain tax attributes. This adjustment effectively defers taxable income instead of extinguishing it. An adjustment must be made to the following tax attributes in this order: Net operating losses, general business credits, minimum tax credits, capital loss carryovers, bases of depreciable property, passive activity loss and credit carryovers, and foreign tax credit carryovers.
Adjustments to loss carryovers and depreciable property bases are dollar for dollar of COD income excluded from gross income. On the other hand, the aforementioned credits are adjusted 33 1/3 cents per dollar excluded. Depending on the circumstances, a taxpayer may instead prefer to elect to apply any portion of this reduction to the adjusted bases of depreciable property.
Josh N. Wheeler is a CPA with Crowe Horwath LLP in the Dallas office. He can be reached at (214) 777-5257 or firstname.lastname@example.org. Catherine Fox-Simpson, CPA, is a partner with Crowe Horwath LLP in the Dallas office. She can be reached at (214) 777-5213 or email@example.com.