Stimulus Package's Elective Tax Deferral Could Facilitate Workouts

The American Recovery and Tax Reinvestment Act of 2009 (the Act) was passed by Congress on Friday, Feb. 13, 2009 and sent to the President for signing. The Act contains provisions that could significantly assist businesses in restructuring their debt and strengthening their balance sheets. Specifically, these provisions provide businesses that renegotiate or repurchase their debt obligations with the ability to defer certain tax payments.
 
Under Pre-Act law, if a lender cancels a borrower’s debt or if a borrower buys back its own debt at a discount, issues new debt at a lower issue price in exchange for old debt, or substantially modifies the terms of old debt, the difference between the issue price of the original debt and the amount paid to acquire the debt (or the issue price of the new or modified debt) is generally treated as taxable income known as “CODI.” Under current law, however, debtors in Title 11 bankruptcy and debtors who are insolvent do not recognize the CODI to the extent of their insolvency. Generally bankrupt or insolvent debtors who do not recognize CODI are required to reduce certain tax attributes that provide future tax benefits (e.g., net operating losses and tax basis) by the amount of the unrecognized CODI.
 
The Act permits businesses that repurchase their debt in 2009 and 2010 (or some or all of whose debt is cancelled) to elect to defer the recognition of CODI until the year 2014. Beginning in 2014, the CODI would be taken into income in equal amounts over a five-year period. The provisions of the Act apply to repurchases of debt funded with cash, replacement debt or equity (including stock, partnership interests, and LLC membership interests). In the case of a partnership (or LLC taxable as a partnership), if the deferral election is made, the reduction of debt will not then trigger a deemed distribution to the partners/members to the extent such deemed distribution exceeds the basis of the partners/members. Such deferred deemed distribution will be taken into account at the same time, and in the same amount (up to the then remaining amount), as the deferred income is recognized by the partner/member.
 
For example, consider a corporation that issued a $1,000,000 bond five years ago. In today’s market the bond may be worth only $600,000. If, in 2009 the corporation repurchases the bond with cash, stock or new debt worth $600,000, the company would have $400,000 of CODI. Without the election under the Act, the corporation would owe tax on the $400,000 CODI in 2009. If the corporation were insolvent by $100,000, the insolvency exception (if no election is made under the Act) would permit the corporation to not recognize $100,000 of the CODI (and would be required to reduce its tax attributes by $100,000). Accordingly the corporation would be required to recognize $300,000 of the CODI. If the corporation were insolvent by $400,000 or more (if no election is made under the Act), the corporation would not recognize the CODI and would reduce its tax attributes by $400,000.
 
If a debtor makes the election to defer recognition of CODI, the exclusions for bankruptcy and insolvency will not apply to the CODI in the applicable year of bankruptcy or year when recognized. Partnerships, S corporations and LLCs taxed as partnerships would make the election at the entity level (as opposed to the pass-through owner level) even though the CODI will flow through to the partners/shareholders/ members and be taxable to them. Furthermore, with respect to partnerships (and LLCs taxable as partnerships, but not S corporations) the current bankruptcy and insolvency exclusions for CODI are determined at the partner/member level rather than the entity level (i.e., a partnership’s CODI will flow through to the partners and a bankrupt or insolvent partner could exclude the CODI while a solvent partner could not). If the election is made by the partnership (or LLC  taxed as a partnership), the insolvent or bankrupt partners/members would have to recognize the CODI along with the solvent partners in those future years. If an election has been made and the partner/member later bankrupts, the tax liability will be deemed to arise immediately before the bankruptcy and may or may not be discharged even if the individual is insolvent at the time of the election. For S corporations and partnerships (including LLCs taxed as partnerships), there are significant fiduciary duties for the decision makers that need to be carefully considered before deciding whether to make the election. What benefits some owners may terribly hurt others.
 
Consider the corporation in the above example. If the corporation made the election to defer the recognition of the $400,000 CODI realized in 2009 under the Act, the corporation would recognize $80,000 of CODI per year beginning in 2014 and ending 2018. If the corporation were instead an equal partnership between two individuals, one of whom was solvent and the other of whom was insolvent, each partner, including the insolvent partner, would recognize its share of CODI in those future years.
 
If the deferral election is made and the new indebtedness has original issue discount (OID), the OID interest deduction is generally suspended until the CODI begins to be recognized and such suspended OID is then deductible ratably over the five-year CODI recognition period.
 
The taxpayer’s deferrals (both CODI and OID deductions, if any) are generally accelerated and taken into income in the taxable year in which the taxpayer: (1) dies, (2) liquidates or sells substantially all its assets (including in a title 11 or similar case), (3) ceases to do business, (4) is in similar circumstances, or (5) with respect to the owners of a pass-through entity, upon the sale, exchange or redemption of such owner’s interest in the entity. In a case under title 11 or similar proceeding, any deferred items are taken into account as of the day before the petition is filed unless the title 11 case is successful and the taxpayer emerges from the proceeding.
 
The CODI deferral election is on an instrument by instrument basis, but once made is irrevocable. For example a business has two lenders with which it negotiates major modifications of the respective loans in 2009. The business may elect to defer the CODI with respect to lender one and not elect to defer the CODI with respect to lender two.
 
The CODI provisions of the Act provide struggling businesses with an opportunity to renegotiate their debt outside of bankruptcy without triggering an immediate tax liability. However, prior to making the election, a debtor should consider the exclusions under existing law that will not be available if the debtor chooses to make the election. As illustrated above, the election may not be the best solution for all taxpayers and special considerations must be made when making an election for a partnership, S corporation, or LLC.