© michael best & friedrich llp 2009 working out and restructuring distressed debt – tax traps...

© Michael Best & Friedrich LLP 2009

WORKING OUT AND RESTRUCTURING DISTRESSED DEBT – TAX TRAPS AND

TECHNIQUES TO ACHIEVE FAVORABLE OUTCOMES

Richard A. LattaMichael Best & Friedrich LLP

One South Pinckney Street, Suite 700Madison, WI 53703

(608) [email protected] www.michaelbest.com

State Bar of Wisconsin 60th Annual Tax School

December 1, 2009

mailto:[email protected]

© 2009 Michael Best & Friedrich LLP 2

MISSION

To legally reduce to a nominal amount the income tax paid upon debt and mortgage restructuring, workout or forgiveness of debt (a/k/a “Cancellation of Debt” or “COD”).


VISION

Create a toolbox that allows practitioners to address debt and mortgage restructuring, workout and forgiveness situations.


WHAT’S THE PROBLEM?

If the bank is willing to restructure the debt and forgive part of it – that’s great! But –

United States v. Kirby Lumber Co., 284 U.S. 1 (1931) – The U.S. Supreme Court established the rule that a debtor realizes (and must recognize) income when discharged of indebtedness. That is, when a debtor is relieved of indebtedness without full payment of the amount owed, the debtor realizes taxable income in the form of COD.

In Kirby Lumber, the taxpayer issued bonds for which it received par value. In the same year, the taxpayer repurchased some of those bonds in the open market for less than their par value issue price. The Supreme Court held the taxpayer must recognize income in an amount (in that case $137,521) equal to the difference between the issue price and the repurchase price of the bonds. In so holding, the Supreme Court reasoned: “As a result of its [taxpayer’s] dealings, it made available $137,521.30 [of] assets previously offset by the obligation of the bonds now extinct.”


KIRBY LUMBER IS CODIFIED

IRC § 61(a)(12) says:

“[G]ross income means all income from whatever source derived,

including …

(12) Income from discharge of indebtedness … .”


HOW WILL YOU PAY THE TAX ON THE COD?


WHAT TRIGGERS COD/TAXABLE GAIN?

The two most common COD events are:

Forgiveness of debt – Kirby Lumber; IRC § 61(a)(12). Modification of debt/restructuring – Treas. Reg. § 1.1001-3.

Taxable gain under IRC § 1001(c) arises where there is:

Foreclosures, deeds-in lieu and other transactions where an asset is transferred to satisfy a debt. Rev. Rul. 90-16, 1990-1 CB 12.

A “debt shift” in a partnership that gives rise to taxable gain as a result of IRC § 752(b).


BASIC TOOLS

The principal tool to exclude COD is in one section – IRC § 108:

Per the legislative history of the 1980 Bankruptcy Tax Act, Section 108 was enacted to permit taxpayers who otherwise would have taxable income resulting from forgiveness of debt to not be burdened with an immediate tax liability. See S. Rpt. 96-1035, 1980-2 C.B. at 624 (1980).

But, there is no exclusion for taxable gain arising under § 1001(c).

So, depending upon the facts, COD that can be excluded from income can be better than taxable gain.


Five principal parts of IRC § 108, which provides the exclusion from income for COD, are where the:

Discharge occurs in bankruptcy (a Title 11 case); § 108(a)(1)(A). Discharge occurs when the taxpayer is “insolvent”; § 108(a)(1)(B). Debt is “qualified farm indebtedness”; § 108(a)(1)(C). Debt discharged is “qualified real property business indebtedness”; §108(a)

(1)(D). Debt discharged is “qualified principal residence indebtedness” discharged

before January 1, 2013; § 108(a)(1)(E).

There’s also a new five-year deferral – not exclusion – for COD to 2014 to 2018 for COD arising in 2009 or 2010; § 108(i). An election to defer under § 108(i) takes precedence over the exclusions in (A) to (E), above. § 108(i)(5)(C).


NOTHING IS FREE – SO WHAT’S THE COST?

The cost of exclusion of COD is the debtor must reduce tax attributes by the amount of the COD excluded. § 108(b)(1).

Unless all seven of the tax attributes listed in § 108(b) are exhausted, the exclusion under § 108 is not a permanent exclusion but is, in effect, a deferral of COD.

If all seven tax attributes are exhausted, then the exclusion is permanent.


WHAT ARE THE ATTRIBUTES?

The seven attributes reduced under § 108(b)(2) are:

(A) Net operating losses (a/k/a “NOLs”).

(B) General business credits allowable under § 38.

(C) The minimum tax credit available under § 53(b).

(D) Capital loss carryovers.

(E) The tax basis of property of the taxpayer (note: this is “tax basis” and not “depreciable basis” – more on this below).

(F) Any passive activity loss or credit carryovers under IRC § 469(b).

(G) Foreign tax credits allowable under § 27.


AMOUNT OF REDUCTION

The reductions are made after determination of tax for the taxable year in which the COD occurs. § 108(b)(4)(A).

For attributes in dollar amounts, the attributes are reduced on a dollar-for-dollar basis of the excluded COD. § 108(b)(3)(A).

For tax credits, the reduction is 33-1/3 cents for each dollar of excluded COD. § 108(b)(3)(B).


SPECIAL ELECTION FOR DEPRECIABLE PROPERTYThe attribute reduction under § 108(b)(2) for basis is for any “basis of the property of the taxpayer.” § 108(b)(2)(E).

Under IRC § 108(b)(5), there is a special election to apply the attribute reduction first against depreciable property. As a result of applying the attribute election against depreciable property, this special election:

Reduces future depreciation of the taxpayer – thereby highlighting the deferral aspect of § 108.

Only applies to depreciable property -- so land and other assets that are not depreciable don’t qualify for the special election.


COD FROM BANKRUPTCY

The exclusion from COD arising in bankruptcy only applies if:

The taxpayer is under the jurisdiction of the bankruptcy court; and

The COD arises as a result of a forgiveness of debt by the court or pursuant to a plan approved by the bankruptcy court. § 108(d)(2).

So, the exclusion does not apply to COD that arises from a discharge either before the bankruptcy case or after termination of the bankruptcy.


INSOLVENCY EXCEPTION

In light of the stigma associated with bankruptcy, the most commonly used COD exclusion is the “insolvency” exception under §108(a)(1)(B).

The term “insolvent” means the excess of liabilities over the fair market value of a taxpayer’s assets. § 108(d)(3).

The test of insolvency is determined immediately before the discharge giving rise to the COD. § 108(d)(3).


WHAT’S AN ASSET?

The definition of what is an “asset” for purposes of “insolvency” has been the subject of much litigation. The principal question is whether assets exempt from the claims of creditors under applicable state law are included in “assets” for purposes of the insolvency determination.

Ultimately, this is a question of policy because under the bankruptcy exception assets exempt from creditors under state law are not treated as an asset of the taxpayer.


IS THERE A “FREEING OF ASSETS”?

After two decades of courts and taxpayers taking multiple positions on what is an asset, the tax court in Carlson v. Commissioner, 116 T.C. 87 (2001) held:

The legislative history showed that the Bankruptcy Tax Act of 1980 adopted a “freeing of assets theory”.

Hence, assets exempt from the claims of creditors under applicable state law are included when determining the fair market value of a taxpayer’s assets for purposes of ascertaining whether the taxpayer is “insolvent”.

The Court’s rationale was if a taxpayer’s total assets – including exempt assets – exceeds the debtor’s liabilities, the debtor has the ability to pay an immediate tax on income from COD.


WHAT’S A LIABILITY?

The term “liability” for purposes of insolvency was no easier to answer but only took 17 years after the Bankruptcy Tax Act of 1980 to resolve.

In Merkel v. Commissioner, 109 T.C. 463 (1997), the Tax Court held that the term “liabilities” requires the taxpayer to prove that the taxpayer will be called upon to pay the obligation in the amount claimed.

Failure to prove the taxpayer would be called upon to pay the amount of the obligation results in the obligation not being a “liability” for purposes of the insolvency determination.


WATCH THE SPECIAL RULES

In the case of individuals and C corporations, the tests for bankruptcy and insolvency are straight forward. The determination is made at the individual or C corporation level.

For pass-through entities, the rules are not as easy.


FOR PARTNERSHIPS

Where the entity in bankruptcy or potentially insolvent is a partnership, then the exclusion of COD is applied at the partner, not the partnership, level. § 108(d)(6).

This means that if a partner is not in bankruptcy or insolvent, then the partner will have taxable COD from the discharge of debt, despite what’s occurring with the partnership.


WHAT ABOUT S CORPS?

For S corporations, the provisions of § 108 are generally applied at the S corp level.

So, if the S corp is in bankruptcy or insolvent, then the bankruptcy or insolvency determination is made at the S corp, and not the shareholder, level. § 108(d)(7).

This result was affirmed by Gitlitz v. Commissioner, 531 U.S. 206 (2001), which permitted basis for COD excluded by the S corp, thereby allowing utilization of NOLs by the S corp shareholders. This decision was reversed by Congress in 2002 (i.e., no basis for excluded income under § 1367(a)).

So there may be situations where interposing an S corporation may be beneficial.


OTHER SPECIAL RULES

There are a series of special rules in § 108(e) that can be traps for the unwary. They include:

Accrued interest and expenses – there is no income (i.e., no COD) to the extent that the payment of a liability would give rise to a deduction. § 108(e)(2).

This means if a cash basis taxpayer has not previously deducted the amount, then the forgiveness of the expense does not give rise to COD.

Related party acquisitions of debt – if a party related to an obligor acquires the obligor’s debt, the acquisition is treated as if the obligor reacquired the debt, thereby potentially creating COD. § 108(e)(4).

The rule also includes an expanded definition of who counts as “related” that is broader than general relationship rules under the Internal Revenue Code.


OTHER SPECIAL RULES (cont.)

Stock for debt – where a company exchanges stock for debt, the exchange will typically give rise to COD. § 108(e)(6), (e)(7) and (e)(8).

Partnership interest for debt – while for many years taxpayers took the position that an exchange of a partnership interest for debt did not give rise to COD, in 2004 Congress changed the Code to provide that a partnership interest exchanged for recourse or nonrecourse debt gives rise to COD. § 108(e)(8).

Debt for debt exchanges – also give rise to COD to the extent of the “issue price” of the new debt instrument (determined under the OID rules) is less than the amount of debt discharged. § 108(e)(10).


WHAT ABOUT LAND CONTRACTS?

If there is a reduction in the purchase price between a seller and a buyer where a note between the seller and the buyer is reduced, then the reduction can be treated as a purchase price adjustment and not as COD. § 108(e)(5).

This special rule for purchase money debt reduction is especially helpful when the buyer is not in bankruptcy and not insolvent.


WHAT IS “RECOURSE” v. “NONRECOURSE” DEBT?

The definition of “recourse” and “nonrecourse” debt is one of the most difficult issues yet to be resolved.

In light of carve-outs in loan agreements (e.g., liability of borrower for environmental issues), it becomes difficult to determine whether debt is recourse or nonrecourse.


§ 1001 GAIN RULES

The § 1001 rules regarding taxable gain highlight why it is important to determine whether the underlying debt is recourse versus nonrecourse.

Recourse debt receives bifurcated treatment. Treas. Reg. § 1.1001-2(c), Example 8.

Nonrecourse debt gives rise to taxable gain. § 7701(g).


BIFURCATED TREATMENT FOR RECOURSE DEBTWhere a debt is recourse, then the amount of debt forgiveness that exceeds the fair market value of property transferred is treated as COD, and the fair market value of the property transferred becomes the amount realized for determining gain under § 1001.

Example 8, Treas. Reg. § 1.001-2(c) describes how this calculation works. It says:

In 1980, F transfers to a creditor an asset with a fair market value of $6,000 and the creditor discharges $7,500 of indebtedness for which F is personally liable. The amount realized on the disposition of the asset is its fair market value ($6,000). In addition, F has income from the discharge of indebtedness of $1,500 ($7,500 minus $6,000).


IMPACT ON FORECLOSURE OF PROPERTY

Although foreclosures typically result in an economic loss to the obligor and owner of the property, it is common for the owner of the property to realize taxable gain due to the low tax basis of the property.

Although an involuntary act, foreclosure is treated as a sale or exchange of the property by the taxpayer.

As shown by Example 8, the gain or loss from the foreclosure is determined in the same manner as an ordinary sale of property.

For recourse debt, the amount above the fair market value of the property is then treated as COD.

Under the applicable case law, the amount bid in at a foreclosure proceeding will, absent other evidence, be treated as the fair market value of the property. See Carlson v. Commissioner, 116 T.C. 87 (2001).

In a foreclosure transaction where there is recourse debt, the transaction is bifurcated and treated as part sale or exchange under § 1001 to the extent of the “fair market value” of the property, and part discharge of indebtedness resulting in COD.


WHAT ABOUT IF THE DEBT IS NONRECOURSE?The amount realized upon the foreclosure of property securing nonrecourse debt is equal to the face amount of the debt discharged, regardless of the property’s fair market value. Tufts v. Commissioner, 461 U.S. 300 (1983); § 7701(g).

The importance is that there is no exclusion for taxable gain.

So while the rate for taxable gain is currently lower than COD, there are situations where taxpayers will have a better result with a recourse debt as compared to nonrecourse debt.


CONSEQUENCES OF DEBT MODIFICATION--SECTION 1001 REGULATIONS

One of the issues that can arise in a debt restructuring is whether a modification to the terms of a loan results in the issuance of new debt under the debt modification rules of Treas. Reg. § 1.1001-3. If a modification results in the issuance of new debt, then there can be:

Recognition of income or loss on the part of creditors, and

Possible COD income to the debtor.


THE COTTAGE SAVINGS CASE

Treas. Reg. § 1.1001-1(a) provides income realization occurs “from the exchange of property for other property differing materially either in kind or in extent … .”

These regulations were construed by the Supreme Court in Cottage Savings Ass’n v. Comr., 499 U.S. 554 (1991), where there was an exchange of a 90% “participation interest” in a portfolio of mortgages for a 90% participation interest in another portfolio of mortgages of equivalent value. In Cottage Savings, the Supreme Court held:

There was an event of realization for purposes of § 1001(a).

The “materially different” standard of Treas. Reg. § 1.1001-1 was satisfied, so there was an exchange resulting in the recognition of a tax loss.


TREAS. REG. § 1.1001-3

In 1996, the IRS issued regulations that provide an exchange of an instrument for another instrument differing materially either in kind or in extent is deemed to occur if there is a “significant modification” of a debt instrument. Treas. Reg. § 1.1001-3(b).

In general, a modification is defined as an alteration in any legal right or obligation. Treas. Reg. § 1.1001-3(c)(1)(i).

The regulations are highly fact specific—so if a modification is within the scope of what’s described below, check the regulations.


WHAT’S A “SIGNIFICANT MODIFICATION”?

Generally, a modification is a significant modification if based on all the facts and circumstances the legal rights of obligations that are altered and the degree to which they are altered are economically significant. Treas. Reg. § 1.1001-3(e)(1).

Where a series of modifications has taken place, the modifications are considered collectively, so a series of modifications may be significant even though the individual modifications are not. Id.


EXAMPLES OF “SIGNIFICANT MODIFICATIONS”Significant modifications include:

Change of Yield of More Than 25 Basis Points. A change in the annual yield by more than:

¼ of 1% (i.e., 25 basis points), or

5% of the annual yield of the unmodified instrument (i.e., 0.05 x annualized yield). Treas. Reg. §§ 1.1001-3(e)(2)(ii) and 1.1001-3(g), Example 3.

Deferral of Scheduled Payments. A change in the timing of payments if it results in the material deferral of scheduled payments. Treas. Reg. § 1.1001-3(e)(3)(i).

There is a safe-harbor period for where the first scheduled payment is deferred and extends the scheduled payments for the lesser of (i) five years or (ii) 50% of the original term of the instrument. Treas. Reg. § 1.1001-3(e)(3)(ii).


EXAMPLES OF “SIGNIFICANT MODIFICATIONS” (cont.) New Obligor on Recourse Debt. Subject to limited exceptions, a

substitution of a new obligor on a recourse debt instrument is a significant modification. Treas. Reg. § 1.1001-3(e)(4)(i).

Alteration of Collateral on Recourse Debt. The alteration of (1) the collateral, (2) a guarantee, or (3) other form of credit enhancement relating to a recourse debt, if the modification results in a change in payment expectations. Treas. Reg. § 1.1001-3(e)(4)(iv)(A).

Substantial Change in Collateral on Nonrecourse Debt. Subject to limited exceptions, (1) an alteration of a substantial amount of the collateral, (2) a change in guarantee, or (3) other form of credit enhancement relating to a nonrecourse debt instrument is a substantial modification. Treas. Reg. § 1.1001-3(e)(4)(iv)(B).

However the addition of a building or improvement as part of the collateral may not be a significant modification. Treas. Reg. § 1.1001-3(g), Example 9.


Change in Priority. A change in the priority of a debt instrument relative to other debt of the obligor if the change in priority results in a change in payment expectations. Treas. Reg. § 1.1001-3(e)(4)(v).

Change From Nonrecourse to Recourse. A change from a recourse debt to a nonrecourse debt or vice versa, subject to exceptions for (1) certain tax exempt bonds and (2) modification of a recourse debt instrument to a nonrecourse debt where the debt continues to be secured by the original collateral and the modification does not change payment expectations. Treas. Reg. § 1.1001-3(e)(5)(ii).

EXAMPLES OF “SIGNIFICANT MODIFICATIONS” (cont.)


WHAT’S NOT A SIGNIFICANT MODIFICATION?What’s not a significant modification includes:

Modification by Operation of the Original Instrument. Generally, a significant modification doesn’t include an alteration that occurs by operation of the original instrument.

This includes a unilateral exercise of a right under the instrument, subject to enumerated exceptions. Treas. Reg. §§ 1.1001-3(c)(1); -3(c)(2)(iii).

However, a change in obligor or in the nature of the instrument from recourse to nonrecourse or vice versa is a significant modification even if it occurs by operation of the original debt instrument. Treas. Reg. § 1.1001-3(c)(2).

Change in Accounting or Financial Covenants. A modification that adds, deletes or alters customary accounting or financial covenants is not a significant modification. Treas. Reg. § 1.1001-3(e)(6).


WHAT’S NOT A SIGNIFICANT MODIFICATION? (cont.)

Failure to Perform. The failure of the obligor to perform under the debt obligation. Treas. Reg. § 1.1001-3(c)(4).

Agreement to Forbear. Agreement by the lender to forebear collection or temporarily waive an acceleration clause or similar default right, unless the forbearance exceeds (i) two years, (ii) any additional period in which the parties conduct good faith negotiations, or (iii) the borrower is in bankruptcy. Treas. Reg. § 1.1001-3(c)(4)(ii).


COD INCOME

Where there is either an (1) actual or (2) deemed exchange of debt instruments, the exchange constitutes a satisfaction of the old debt instrument by the issuance of the new debt instrument that can give rise to COD.

General Rule – COD If Property Given Is Less Than Adjusted Issue Price. Generally, outside the area of debt-for-debt exchanges, a debtor realizes COD to the extent the fair market value of property or the amount of money given in satisfaction of a debt is less than the adjusted issue price (as defined in Treas. Reg. § 1.1275-1(b)) of the debt. Treas. Reg. § 1.61-12(c)(2)(ii).

Rule for Debt for Debt Exchanges. If a debt instrument is issued in satisfaction of indebtedness, the obligor is treated as having satisfied the old indebtedness with an amount of money equal to the issue price of the new debt instrument for purposes of determining the obligor’s income from the discharge of indebtedness. § 108(e)(10). For this purpose, generally, issue price is determined under §§ 1273 and 1274.


HOW IS ISSUE PRICE DETERMINED?

The rules for determining the issue price of new debt issued for old debt are different for (a) publicly traded debt, as compared to (b) nonpublicly traded debt.

Publicly Traded Debt. If the new issue or the old issue is publicly traded, the issue price of the new issue is determined by the public trading price. § 1273(b)(3).


HOW IS ISSUE PRICE DETERMINED? (cont.)

Non-Publicly Traded Debt. If neither the new nor the old debt is publicly traded, the issue price of the new debt must be determined under the rules of § 1274, if that section applies. § 1273(b)(4).

Section 1274 applies to debt instruments issued for property where some or all of the payments are due more than six months after the sale or exchange, subject to a number of exceptions and limitations, including an exception for (1) sales involving total payments of $250,000 or less, and (2) sales of farms with a sales price not exceeding $1,000,000. § 1274(c).



Adequate Stated Interest. The issue price of a debt instrument issued for property equals the stated principal amount where there is adequate stated interest. §§ 1274(a)(1); 1274(c)(1)(A).

Adequate Stated Interest. Whether there is adequate stated interest generally depends on whether the interest rate exceeds the “Applicable Federal Rate” (or “AFR”). For October 2009 the AFR (compounded on a semi-annual basis) is (see Rev. Rul. 2009-33):

Loans not over 3 years 0.75% Loans over 3 years but not over 9 years 2.64% Loans over 9 years 4.06%



Not Adequate Stated Interest. Where there is not adequate stated interest, the issue price of the debt instrument is its imputed principal amount. § 1274(c)(1)(A)(ii).

Imputed Principal Amount. The imputed principal amount is defined as the sum of the present values of all payments due under the debt instrument, computed using a discount rate equal to the applicable federal rate compounded semiannually. IRC § 1274(b).



Interest Above Applicable Federal Rate. Generally, where neither the new nor the old issue is publicly traded and § 1274 does not apply because, for example, the interest rate exceeds the AFR (e.g., a bank loan), the issue price of a debt instrument issued for property is its stated redemption value at maturity. §§ 1273(b)(4); 1274(c)(1)(A).

Reduce Stated Redemption Price for Imputed Interest. Section 1273(b)(4) must be applied by reducing the stated redemption price of any instrument by the portion of the stated redemption price that is treated as interest. § 108(e)(10)(B).


SPECIAL RULE FOR REAL ESTATE DEVELOPERSAfter the 1990-1992 recession, Congress enacted a special rule for real estate developers under § 108(c).

The election is voluntary and is useful where the debt was incurred or assumed to acquire, construct, reconstruct or substantially improve real property or, in certain cases, resulted from refinancing indebtedness incurred or assumed before January 1, 1993. § 108(c)(3).

One catch – the election only applies with regard to reducing basis of depreciable real property. It does not apply to land or other non-depreciable real property.

So if all the real estate person has is land held for development, then the exception is not valuable.


FORGIVENESS OF DEBT FOR PRINCIPAL RESIDENCES

In the 1990-1992 recession, certain taxpayers found that their house was worth less than the debt against it. However, they couldn’t walk away because they would have to pay tax on the COD. § 108(h).

For tax years 2009, 2010, 2011 and 2012, taxpayers will be eligible to exclude from income COD arising solely from debt discharged if the debt is directly related to a decline in the value of the taxpayer’s principal residence or the financial condition of the taxpayer. §108(a)(1)(E), (h)(3).

The exclusion is generally limited to mortgages on principal residences of $2 million or less.

The amount excluded reduces the basis of the taxpayer’s principal residence.


DEFERRAL AND RATABLE INCLUSION FROM BUYING BACK DEBT

As part of the American Recovery and Reinvestment Tax Act of 2009, a new deferral rule was enacted allowing taxpayers for 2009 and 2010 to elect to include the COD from reacquiring debt for less than its face value over a five-year period beginning in 2014 and ending in 2018. §108(i).

The election to have the five-year deferral to 2014 to 2018 contains rules for how to allocate debt for C corporations and for pass-through entities and authorizes the IRS to promulgate legislative regulations regarding the deferral.

There are rules for acceleration of the deferral in the event of the death of a taxpayer, liquidation of the taxpayer (including in bankruptcy) or cessation of business by the taxpayer.

Guidance on how to elect the deferral has been issued at Rev. Proc. 2009-37.


WHAT IF OBLIGOR IS A RELATIVE?

If the debtor is related to the lender as a family member, then the IRS takes the position that cancellation of the debt is a gift. If the amount of the gift exceeds the applicable gift threshold, then the gift can become a taxable gift.

If the gift is a taxable gift, and the debtor is insolvent, there is case law authority that the amount of the gift is limited to the amount by which the debtor becomes solvent.


PARTNERSHIP DEBT SHIFT

In a partnership, partners are treated as having tax basis equal to the amount of debt allocated to the partner. IRC § 752.

When partnership debt is forgiven, partners can find the debt that previously supported a “negative capital” account decreases or is shifted to other partners. This is treated as a distribution of cash. §752(b).

If the § 752(b) distribution exceeds the partner’s tax basis in the partnership interest, taxable gain results.


WHO CARES ABOUT COD? HOW WILL THE IRS KNOW?In 1993, IRC § 6050P was enacted, which requires the filing of a Form 1099-C where there has been a discharge of debt of $600 or more by an “applicable financial entity”. § 6050P(a) and (b). An “applicable financial entity” means:

Any bank or other financial institution described in §§ 581 or 591(a) and any credit union. § 6050P(c)(2)(A).

Federal agencies such as the FDIC, the RTC and the National Credit Union Administration. § 6050P(c)(2)(B).

Subsidiaries of banks and financial institutions if they are subject to federal or state supervision and examination. § 6050P(c)(2)(C).

Any “organization, a significant trade or business of which is the lending of money.” § 6050P(c)(2)(D).

This category of financial entities was intended to encompass financial companies and credit card companies whether or not affiliated with banks or financial institutions. Treas. Reg. § 1.6050P-2.

Organizations selling non-financial goods or providing non-financial services (such as a manufacturing or retail business) that extend credit to the purchasers of those goods or services are not in a significant trade or business of lending money. Treas. Reg. § 1.6050P-2(c).


WHAT TRIGGERS A FORM 1099-C?

A Form 1099-C is to be furnished to the person who receives a discharge of more than $600 of COD income by January 31st of the year following the discharge. § 6050P(d).

Under Treas. Reg. §1.6050P-1(b), the events triggering the Form 1099-C filing requirement is where a debt is discharged upon the occurrence of an identifiable event indicating that the debt will not have to be paid by the debtor. An identifiable event includes:

A discharge of debt under the Federal bankruptcy laws. Treas. Reg. § 1.6050P-1(b)(2)(i)(A).

An agreement between a financial institution and the debtor to discharge a debt (including an agreement that results in an exchange under § 1001) provided that the last event to effectuate the discharge has occurred. Treas. Reg. § 1.6050P-1(b)(2)(i)(B).

A cancellation or extinguishment by operation of law that renders the debt unenforceable – such as the expiration of the statute of limitations for collection of the indebtedness. Treas. Reg. § 1.6050P-1(b)(2)(i)(C).


WHAT TRIGGERS A FORM 1099-C? (cont.)

What is not an identifiable event is a bookkeeping entry (such as a deduction for book or regulatory reporting purposes). While not in and of itself an identifiable event, such an action can be an identifiable event if it is a defined policy of a creditor. Treas. Reg. §§ 1.6050P-1(b)(2)(i)(G) and -1(b)(2)(iii).


BRINGING IT ALL TOGETHER

The above principals are highlighted by an example.

Problem:

ABC Partnership has been in business a number of years but recently suffered because of the economic downturn. Its primary asset is a manufacturing plant where it brews world-class beer. Despite the interest of consumers in drowning their sorrows, the beer is not selling. The manufacturing facility has a tax basis of $1 million, a fair market value of $2 million and is subject to debt of $4 million.

ABC has four equal general partners, Big Jim “Potbelly” Walker, Donald “Big Hair” Developer, Water Street Brewers, LLC, and Noseeum, Inc.


Big Jim “Potbelly” Walker is a successful and wealthy individual with a net worth in excess of $50 million (i.e., he is “hopelessly solvent”).

Donald “Big Hair” Developer is a real estate developer who finds himself a bit over-extended as a result of the downturn in the real estate market. He has personal liabilities for debts in excess of $50 million and his projects are underwater by $15 million. Being a developer he is confident things will turn around soon and he will be fine.

Water Street Brewers, LLC is a family-limited liability corporation. Not much is known about the profiles of the individual members but it is believed that there are over 10 individual members all related to the founder of the century-old brewery.

Noseeum, Inc. is an S corporation that was carrying an active business of a brewery, where the brewery business was contributed to ABC Partnership. Noseeum now has its partnership interest in ABC Partnership and about $200,000 of cash that it is ready to distribute to its sole shareholder.


ABC Partnership asks you if you can represent ABC Partnership in negotiating a workout with its creditors and/or a possible bankruptcy. ABC Partnership is interested in avoiding undesirable tax consequences for its partners.

© michael best & friedrich llp 2009 working out and restructuring distressed debt – tax traps...

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