The Importance of Determining the Tax Effects of Debt Cancellation in a Business Workout or Reorganization
As the Great Recession has plagued the American economy, many real estate businesses have had to resort to bankruptcy, workouts, and restructurings to survive. Obviously, one of the primary purposes of these procedures is to achieve some level of debt cancellation. But, debt cancellation does not come without consequences, and one of the most important issues in these types of proceedings is cancellation of debt (COD) income.
COD income can result from a number of different maneuvers, including the cancellation of debt by a creditor, cancellation of debt by operation of law, a debtor’s acquisition of its own debt, the acquisition of debt by a party related to the debtor, and modifications to the terms of a debt instrument.
Dealing with the various tax challenges that arise in a workout or reorganization can be difficult. The first step in doing so is determining whether the proposed resolution will cause COD income. Generally speaking, the rule on this issue is fairly straightforward: If a debtor’s debt is cancelled, then the debtor has taxable income.
This principle is based on well-settled federal statutory and case law. Debtors sometimes have a hard time coming to grips with COD income because it is really “phantom” income. In other words, the debtor is required to recognize COD income as taxable income, even though the debtor did not receive any cash from the transaction.
Many times debtors will incur tax losses before they reach a debt cancellation situation. However, in certain circumstances a debtor may not incur tax losses before needing debt cancellation, and even when a debtor has unused tax losses, they may not be able to use them to offset COD income.
Fortunately for businesses that find themselves in this situation, there are a number of exceptions to the general principle that COD income is taxable. For this reason, it is extremely important for the proper legal analysis to be done in order to determine what the tax treatment will be of a workout or reorganization involving debt cancellation.
COD income can result from a number of different maneuvers, including the cancellation of debt by a creditor, cancellation of debt by operation of law, a debtor’s acquisition of its own debt, the acquisition of debt by a party related to the debtor, and modifications to the terms of a debt instrument.
Dealing with the various tax challenges that arise in a workout or reorganization can be difficult. The first step in doing so is determining whether the proposed resolution will cause COD income. Generally speaking, the rule on this issue is fairly straightforward: If a debtor’s debt is cancelled, then the debtor has taxable income.
This principle is based on well-settled federal statutory and case law. Debtors sometimes have a hard time coming to grips with COD income because it is really “phantom” income. In other words, the debtor is required to recognize COD income as taxable income, even though the debtor did not receive any cash from the transaction.
Many times debtors will incur tax losses before they reach a debt cancellation situation. However, in certain circumstances a debtor may not incur tax losses before needing debt cancellation, and even when a debtor has unused tax losses, they may not be able to use them to offset COD income.
Fortunately for businesses that find themselves in this situation, there are a number of exceptions to the general principle that COD income is taxable. For this reason, it is extremely important for the proper legal analysis to be done in order to determine what the tax treatment will be of a workout or reorganization involving debt cancellation.