Federal Income Tax and the Financially Troubled Corporation

^{*Reprinted with permission from the American Bankruptcy Institute’s Commercial and Regulatory Law Committee Newsletter, www.abi.org. Copyright © 2023 all rights reserved.}

A financially troubled corporation confronts many issues, including those raised by federal income tax law. While relevant income tax law is based on a few policies that are relatively simple to summarize, implementation of these policies drives significant complexity.

This article discusses the policy framework first, then provides a brief overview of some of the most significant issues that arise from implementing the policy framework. The goal is to provide bankruptcy counsel who do not specialize in federal income tax a general understanding of why effective income tax planning is so important to corporations reorganizing in bankruptcy or out of court.

Policy Background

A fundamental policy of the Bankruptcy Code is to encourage and facilitate rehabilitation of financially troubled debtors, giving them a fresh start. A fundamental policy of income tax law is that receipt of loan proceeds does not create income subject to tax because the cash received is merely a loan that is intended to be repaid. When a debt is settled for less than the full amount owed, the excess of debt owed and no longer payable is recognized as taxable income. This excess is referred to as cancellation of debt income, or “CODI.”  

These policies have the potential to work at cross purposes. If CODI was included in taxable income when realized on plan confirmation or closing an out-of-court debt workout, the reorganized debtor could be liable for a large income tax, potentially threatening its fresh start. On the other hand, if CODI was never included in taxable income, the tax law policy of taxing CODI would be frustrated. To effectuate both policies, tax law generally does not subject CODI to immediate taxation but seeks to recover such tax in the future as the reorganized business returns to profitability.

The basic mechanics are found in two Internal Revenue Code sections and several sets of income tax regulations.   These rules do two things. First, in specified situations, including bankruptcy and out-of-court debt workouts of insolvent corporations, the rules exclude CODI from income, thus giving effect to the fresh start policy. Second, the rules require that the debtor give up certain tax assets that, if realized in the future, would normally reduce taxable income. This is intended to implement the policy of taxing CODI by making the tax effect of excluding CODI from taxable income temporary rather than permanent.

A Few Words About Tax Assets

Tax assets generally fall into three categories: (1) capital and net operating loss carryforwards; (2) tax credits, such as the foreign tax credit or the general business credit; and (3) tax basis in assets, including fixed assets subject to tax depreciation; intangible assets such as goodwill, which may or may not be amortizable for tax purposes; basis in nondepreciable/amortizable property, such as land that offsets taxable proceeds when such assets are sold; and basis in current assets, such as inventory and accounts receivable. The common element is that each of these tax assets reduces or has the potential to reduce taxable income (loss carryforwards and tax basis) or to directly reduce taxes payable (tax credits) at some point.

It is the reduction of tax otherwise payable that makes tax assets valuable. Preserving as much of this value as possible in the face of CODI, which is excluded from taxable income, is the principal point of income tax planning in most financially troubled company reorganizations.

Reduction of Tax Assets in General

The total amount of CODI excluded from taxable income sets the maximum reduction of tax assets. Only specified tax assets are reduced in a defined order until all excluded CODI has reduced a tax asset, or the debtor runs out of all specified tax assets. In this case, any remaining CODI that has not reduced a tax asset is permanently removed from taxable income.

The order in which tax assets are reduced is:

1. Current net operating loss and NOL carryovers;
2. General business credit carryovers;
3. Minimum tax credits as of a specified date;
4. Current capital loss and capital loss carryovers;
5. Tax basis in assets;
6. Passive activity loss and credit carryovers; and
7. Foreign tax credit carryovers.

With the exception of tax basis, each category must be exhausted before moving down to the next lower category. A special rule can prevent tax basis in assets from being reduced below the amount of liabilities remaining after debt cancellation in some cases. Planning to benefit from this rule is often very important.

Another important point about basis-reduction is that basis in long-lived assets, including real property and equipment, is generally reduced before basis in current assets, such as inventory and accounts receivable.   However, it is possible to suffer a reduction of basis in current assets. If this happens, extra income tax may be incurred quite quickly, because the taxable gain on inventory sold will be increased and the collection of accounts receivable will generate taxable gain, all potentially in the year following emergence. Again, evaluation of the overall tax posture of the debtor and the terms of the plan of reorganization are critical to identify this issue and allow for planning to eliminate or mitigate an adverse result.

Consolidated Return Groups

If the taxpayer is a parent corporation with one or more subsidiaries filing a consolidated federal income tax return, the rules and necessary analysis become much more complex. From the standpoint of reorganization-planning, the group is often treated as one, particularly if all subsidiaries are 100% owned within the group. In contrast, income tax law requires that each legal entity in the group be respected as a separate tax entity. The regulations integrate application of the CODI and attribute reduction rules that apply to stand-alone corporations with the consolidated group tax rules.

One particular point of note in such cases is that members of a consolidated return group frequently have intercompany receivables and payables amongst themselves. Such intercompany assets and liabilities must be analyzed in the context of understanding how basis-reduction will operate. In certain circumstances, the eventual payment of the intercompany amount can trigger taxable gains if appropriate planning is not done.

Conclusion

Tax laws and their implementation are substantially more complex than this high-level summary of tax policy and basic rules might imply. Within that complexity lie traps for the unwary debtor and planning opportunities for the well-advised debtor. Absent timely, effective analysis and planning, a debtor corporation reorganizing out of court or in bankruptcy may pay more income tax post-reorganization than is necessary, and pay tax sooner than it needs to.

¹_{CODI may also arise from trade payables and accrued liabilities.}

²_{Internal Revenue Code (IRC) §§ 108 and 1017 and associated Treasury Regulations and Treas. Reg. § 1.1502-28. CODI is excluded from gross income where the discharge of indebtedness is granted in a Title 11 case, including chapters 7, 11 and 13. This exclusion applies only if the discharge of indebtedness is granted by a court order or in a court-approved plan. Outside of bankruptcy, CODI can be excluded when a taxpayer is insolvent. Insolvency is defined as the excess of liabilities over the fair market value of assets, determined immediately before the debt discharge and including the debt to be discharged. As such, the amount excluded from income by reason of a debtor’s insolvency cannot exceed the amount of the debtor’s insolvency. Special rules apply to Subchapter S corporations, partnerships including limited liability corporations taxed as partnerships, and limited liability corporations with one member that are disregarded for income tax purposes.}

³_{IRC § 108(b).}

⁴_{IRC § 1017(b)(2).}

⁵_{Treas. Reg. § 1.1017-1(a).}

⁶_{Treas. Reg. § 1.1502-28.}