Tax Aspects of Restructuring Financially Troubled Businesses (Portfolio 541)

Tax Management Portfolio, Tax Aspects of Restructuring Financially Troubled Businesses, No. 541-5th, analyzes the tax implications of restructuring a business’ debt, primarily focusing on out-of-court restructurings as an alternative to foreclosure or bankruptcy. Restructuring debt may allow a financially troubled business to continue operations, but may also result in federal income tax liabilities, such as debt-discharge income, or other adverse tax consequences.

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Tax Management Portfolio, Tax Aspects of Restructuring Financially Troubled Businesses, No. 541-5th, analyzes the tax implications of restructuring a business’ debt, primarily focusing on out-of-court restructurings as an alternative to foreclosure or bankruptcy. Restructuring debt may allow a financially troubled business to continue operations, but may also result in federal income tax liabilities, such as debt-discharge income, or other adverse tax consequences.

Among the topics discussed in this Portfolio are tax consequences that may arise when a business (or a related party) acquires its debt for less than the debt's outstanding balance, and when the business and its creditor modify the terms of outstanding debt. The Portfolio also analyzes the federal income tax consequences of restructuring affiliated groups, modifying partners’ interests in partnerships, and corporate reorganizations, when made as part of debt-restructuring plans.

If an out-of-bankruptcy restructuring is not successful, a business may reorganize under the provisions of the Bankruptcy Code. Bankruptcy tax matters are discussed in detail in 790 T.M., Corporate Bankruptcy , and 791 T.M. Corporate Bankruptcy — Special Topics.

Finally, the Portfolio provides a discussion of the federal tax implications of payments made by guarantors, or other secondary obligors, in satisfaction of guarantee obligations with respect to a financially troubled business, and of the impact of debt restructuring on creditors.


Candace A. Ridgway

Candace A. Ridgway, Jones Day, Washington

Colleen E. Laduzinski, Patrick O'Brien, Benjamin S. Jacobs, Jones Day, New York

Based on an earlier version by, Gregory E. Stern, Esq., Houston, Texas

Table of Contents

Detailed Analysis

I. Introduction

II. Discharge-of-Indebtedness Income

Introductory Material

A. Timing of Discharge

B. Identifying the Debtor

C. Distinguishing Debt Discharge Income from Other Income

D. Disposition of Encumbered Property

1. Recourse Debt

2. Nonrecourse Debt

3. Partially Recourse Debt

E. Disposition of Property Not Subject to Debt

F. Non-Statutory Exceptions to Debt-Discharge Income

1. Contingent or Contested Liabilities

2. Debt-Equity Classification

3. Judicial Purchase-Price Adjustment

a. Nonrecourse Debt

b. Recourse Debt

4. Absence of Increase in Debtor's Assets

G. Statutory Exceptions to Debt-Discharge Income

1. Insolvency

a. Measure of Insolvency

b. Attribute Reduction

2. Bankruptcy

3. Qualified Farm Indebtedness

4. Qualified Real Property Business Indebtedness

a. In General

b. Qualified Real Property Business Indebtedness Defined

c. Excludible Amount

d. Reduction in Basis

e. Partnerships

f. S Corporations

g. Recapture of Basis Reduction

5. Section 108(b)(5) Election to Reduce Basis

a. In General

b. Recapture Upon Disposition

c. Planning Considerations

6. Statutory Purchase - Price Adjustment

7. Capital Contributions

8. Otherwise Deductible Payments

9. Stock for Debt

10. Qualified Business Indebtedness

11. Corporate Transactions with Carryover Attributes

12. Deferral of Income in Certain Debt Restructurings

H. Miscellaneous

1. Discharge of Partnership Debt

2. Discharge of S Corporation Debt

3. Alternative Minimum Tax

a. Net Operating Loss Limitation

b. Adjusted Current Earnings

4. Adjustments to Earnings and Profits

5. Accrued Interest

6. Acquisition of Debt by Related Parties

7. Section 469 Passive Activities

8. Reporting Requirements for Debt Discharge

9. Foreign Debt-Equity Exchanges

III. Modification of Terms of Debt

A. Overview

B. Section 1274 Transactions

1. In General

2. Exceptions to § 1274

a. Assumptions of Debt

b. Publicly Traded Property

c. Debt Instruments with Adequate Stated Interest and No OID

d. Other Exceptions

3. Material Modification

a. Modification as Deemed Exchange

(1) Regulations

(2) Case Law and Prior IRS Rulings

b. Modification of Installment Obligation

c. Planning for Debt-Discharge Income

d. Potentially Abusive Situations

e. Nonrecourse Debt as Bona Fide Debt

f. Assumption and Modification of Debt

g. Election to Treat Debt Substitutions as Realization Event

C. Section 483 Transactions

D. Debt Issued with Property Rights

1. Publicly Traded Debt Instruments

2. Nonpublicly Traded Debt Instruments

E. Contingent Payment Debt Instruments

1. Debt Instruments Issued for Money or Publicly Traded Property

2. Debt Instruments Issued for Nonpublicly Traded Property

IV. Special Considerations for Partnerships

A. Modification of Partners’ Interests in the Partnership

1. Allocation of Partnership Liabilities

a. Liability Defined

b. Recourse Liabilities

c. Nonrecourse Liabilities

d. Partial Recourse Liabilities

2. Consequences of Liability Shift

B. Admission of Creditor as Partner

1. Consequences to Partnership and Existing Partners

2. Creditor

C. Net Profits Interest to Creditor

1. Status as a Creditor

2. Taxation of Net Profits Interest

D. Modifying Terms of Debt

E. Debt-Discharge Income

1. In General

2. Special Allocations of Discharge Income

3. Special Considerations Under § 108

a. Insolvency Computation

b. Purchase-Price Adjustment of § 108(e)(5)

c. Deferral of Debt-Discharge Income Under § 108(i)

4. Deficit Capital Accounts

F. Incorporating the Partnership

1. Direct Contribution of Assets by Partnership

2. Contribution of Assets by Former Partners

3. Transfer of Partnership Interests by Partners

4. Planning Considerations

G. Partnership Mergers and Consolidations

1. In General

2. Publicly Traded Partnerships

H. Disposition of Entire or Partial Partnership Interests

I. Abandonment of Partnership Interests

J. Liquidation of Partnership

K. Distribution of Partner Debt

V. Special Considerations for Corporations

A. Recapitalizations

1. In General

2. Stock for Stock

3. New Stock for Outstanding Debt

a. Consequences to Corporation

b. Consequences to Holder

c. Use of Successor and Related Party Stock

4. New Debt for Outstanding Stock

5. Debt for Debt

a. Consequences to Holder

b. Consequences to Issuer

B. Nontaxable Liquidations and Mergers

1. Liquidation of Subsidiary

a. Qualification Under § 332

b. Section 332 Liquidation

2. Nontaxable Mergers

C. Nontaxable Spinoffs

D. Carryforward of Tax Attributes

1. Section 382

a. Ownership Change

b. Testing Date

c. Calculation of Limitation

2. Special Limitations on Excess Credits

3. Consolidated Return Limitations

4. Acquisitions to Evade or Avoid Tax

5. Limitation on Offset of Built-In Gains

6. Tax Planning for Expiring Loss Carryforwards

E. Contingent Liabilities

1. Taxable Stock Dispositions

2. Taxable Asset Dispositions

3. Section 351 Transfers

4. Nontaxable Reorganizations

F. Incorporation and § 357(c)

G. 2008-2009 Troubled Asset Relief and Incentives

1. The Troubled Assets Relief Program (TARP)

a. Purchases of Troubled Assets of Financial Institutions

b. Guarantee Program for Troubled Assets

c. Executive Compensation Standards for Companies Participating in TARP

d. Federal Financial Assistance Implications of TARP

2. Loss Preservation

a. Testing Date Relief

b. Relaxation of the “Anti-Stuffing” Rule

c. Built-In-Loss Relief for Banks

d. Application of § 382 to TARP Programs

e. Legislative Relief for Restructurings: § 382(n)

3. Temporary Money Market Guarantee Program

4. Securities Lending Transactions

5. Auction Rate Securities

6. Tax-Exempt Bond Market Relief

7. Lending Flexibility for Foreign Corporations

8. Legislative Debt-Discharge Income Relief

VI. Special Considerations for Consolidated Groups

A. Affiliated Status

B. Discharge of Indebtedness

C. Intercompany Transactions

1. In General

2. Regulations

a. Successor Rules

b. Reorganizations

c. Transactions Involving Stock of Members

d. Intercompany Debt

D. Dispositions Outside the Consolidated Group

1. Losses Disallowed on Sale of Subsidiary Stock

2. Deemed Asset Sales Under § 338(h)(10)

3. Effect of Expiring Loss Carryovers

VII. Bankruptcy Considerations

A. Introduction

B. Corporations

1. No Separate Taxable Entity

2. G Reorganization

3. Limitation on NOL Carryforwards

4. Tax Consequences of a Plan of Reorganization (Chapter 11)

a. Debtor

b. Holders

5. Deduction for Worthless Securities

C. Partnerships

D. Priority of Tax Claims

1. Post-Petition Taxes

2. Unsecured Pre-Petition Tax Claims

3. Secured Pre-Petition Tax Claims

a. Avoidance of Tax Liens

b. Secured Tax Claim in Chapter 7

c. Secured Tax Claim in Chapter 11

4. Discharge of Taxes

5. Interest

E. Pre-Petition Tax Planning

1. Timing of Petition Filing

2. Trust Fund Taxes

3. Favorable Forum

VIII. Guarantors, Endorsors, and Indemnitors

A. Status as Guarantor

B. Payments in Satisfaction of Guarantee

C. Payments for Release from Guarantee

1. In General

2. Debt-Discharge Income

IX. Creditors’ Taxation

A. Accrual of Interest

B. Reacquisition of Property

1. Nonpurchase Money Debt

2. Purchase Money Debt

3. Partnership Interest

4. Reporting Requirements

C. Bad Debt Deduction

1. In General

2. Business vs. Nonbusiness Bad Debts

3. Further Limitations

D. Guarantee as Fraudulent Transfer

E. Financial Accounting Standards

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Debt Modification Illustrations of Operation of Sections 1271-1275

Worksheet 2 S. Rep. No. 96–1035, 2d Sess. (1980) (Bankruptcy Tax Act of 1980)