Joe Dawson and Nina Gerbic
Dawson & Gerbic, LLP
Structure of the Presentation
Creditors sometimes provide their debtors relief from the terms of existing liabilities, either voluntarily or involuntarily. When that occurs, debtors and their advisors often consider only the dollar amount and timing of the debt adjustment. They are often unaware of other potential financial consequences of the adjustment, of the rules governing those consequences, and of steps which could dramatically affect those consequences, until it is too late.
The purpose of this presentation is twofold. First, we will suggest an analytical framework for identifying the potential tax and financial statement implications of debt relief transactions which are typically encountered in workout and bankruptcy situations. Second, we will try to identify some combinations of concepts and rules which may enable you to convert potentially painful results of those transactions into opportunities.
We will not focus on the technical requirements of the debt adjustment taxation rules which you regularly hear described at conferences such as this one. We will mention many of those rules, as briefly as we can, to provide background and context for the main focus of our presentation. We will spend some time on some less frequently discussed rules, however. And our discussion will make use of numerous unsupported legal and factual assumptions, each of which could itself be the subject of an hour-long presentation.
Our presentation will begin by briefly identifying the more common forms of debt relief and their general treatment for tax and financial reporting purposes. We will then identify the tax treatments of various types of debt adjustment, either as an amount realized on a sale or exchange, or as discharge of indebtedness income (COD). We will address the relationship of those tax treatments to tax attributes such as loss or credit carryforwards and asset basis. And we will briefly explain some potentially surprising financial statement impacts of debt adjustment transactions.
Our presentation will not look solely at debt reductions, because other changes in debt terms can sometimes have equally significant effects.
In the most common category of debt relief transaction a debtor transfers something to its creditor in at least partial exchange for the debt adjustment. In this type of transaction, a portion of the debt equal to the fair market value of the property given up is normally treated as an amount realized on a sale or exchange.
The tax treatment of sale or exchange transactions is governed by Internal Revenue Code (IRC) sec. 1001. In general, that IRC section calls for computation of potentially taxable gain or loss by subtraction of the property's adjusted basis from any amount realized on the property's disposition. That gain is then taxed, in some cases at favorable capital gains rates.
Any excess of debt reduction over the fair market value of property surrendered to the creditor in a sale or exchange transaction is normally treated as COD for tax purposes.
For financial statement purposes, if collateral or other assets are transferred in full settlement of loans, the debtor should recognize an ordinary gain or loss equal to the difference between the book value of the assets given up and their fair value. The debtor should also recognize an extraordinary gain on restructuring for the difference between the fair value of the assets given up and the book value of the debt.
Numerous other types of transactions can also result in COD for tax purposes. Reductions of debt with no offsetting property transfer normally produce COD. Shareholder contributions of debt to corporate capital can produce COD at the corporate level. COD can result from exchanges and modifications of debt contracts. IRC reclassification provisions, such as sec. 483, can produce COD. And COD can even result from acquisitions of debt, or of creditor entities, where there is no modification to the debt itself.
COD is generally taxed at ordinary income rates, based on IRC sec. 61(a)(12) and the related regulations. There are significant exceptions, however, most of which appear in IRC sec. 108. Some amounts which would seem properly characterized as COD are excluded from income realization for all taxpayers, and troubled debtors are sometimes able to exclude additional amounts which are characterized as COD from gross income for tax purposes. When the latter form of exclusion is available, however, there is often a price exacted in the form of a reduction in beneficial tax attributes.
ANALYTICAL FRAMEWORK FOR DEBT RELIEF EVALUATION
Is the Obligation "Indebtedness"
In general, adjustment of an obligation results in COD under IRC sec. 61(a)(12) or an amount realized on a sale or exchange under IRC sec. 1001 only if that adjustment is properly characterized as a discharge of indebtedness of the taxpayer. Therefore, the first step in evaluating the potential tax effects of a liability adjustment is a determination whether the liability is properly characterized as indebtedness for these purposes. If it is not indebtedness, its adjustment may still be a problem, but it is not today's problem.
Neither IRC sec. 1001, nor Treas. Reg. sec. 1001-2(a)(2), which covers discharge of indebtedness for purposes of that section, defines the term "indebtedness of the taxpayer". The regulation section references IRC sec. 108, however, and that IRC section does provide at least some guidance. IRC sec. 108(d)(1) states that indebtedness of a taxpayer includes any indebtedness for which a taxpayer is liable, or subject to which a taxpayer holds property.
The IRC sec. 108(d)(1) language solves some potential characterization inquiries. Non-recourse liabilities which are secured by property, for example, clearly constitute indebtedness under that IRC provision. IRC sec. 108(d)(1) fails to define indebtedness, however, so it leaves unanswered questions concerning the treatment of certain other types of obligations.
Various commentators suggest that indebtedness for purposes of IRC sec. 108 is probably created only where a taxpayer receives something of value, which it does not include in gross income for tax purposes, in exchange for the taxpayer's promise to pay. That standard has long-standing judicial support. See, E.G., Commissioner v. Rail Joint Co., 61 F2d 751 (2d Cir. 1932). And that standard provides a basis for exclusion of two frequently-encountered types of obligation from characterization as indebtedness.
Guarantors normally receive little or nothing of value which can be excluded from gross income at the time of their guarantees. Because of that, various commentators seem convinced that guarantees and similar contingent obligations should be excluded from characterization as indebtedness for IRC sec. 108 purposes. See Kennedy, Countryman & Williams, Partnerships, Limited Liability Entities and S Corporations in Bankruptcy, 13-19 (2000); Tatlock, 540 T.M., Discharge of Indebtedness, Bankruptcy and Insolvency, A-19 (2000), and the decisions cited therein.
To the extent that there is a bona-fide dispute over the existence or amount of a debt, there has clearly never been the required promise to pay. If the dispute is settled for less than the amount which the creditor originally claimed, the difference should not be considered indebtedness under the suggested standard.
The suggested standard for identifying indebtedness solves some definitional riddles, but it still leaves the proper characterization of many common types of obligations unclear. Tort claims arising from products liability, warranty claims and future rent obligations, for example, represent instances of potential indebtedness where it is difficult to identify or quantify any item of value which the taxpayer received in exchange. Fortunately, however, the next step is our proposed analytical framework effectively side-steps that difficulty in many situations.
Is the Adjustment to the Obligation Tax-free Whether or Not it is Discharge of Indebtedness?
The second step in our suggested analytical framework is the determination whether any governing provisions render our particular liability adjustment tax-free, whether or not it represents discharge of indebtedness. There are such provisions.
As examples, under IRC sec. 108(e)(2), no income is realized from discharge of indebtedness to the extent that payment of the indebtedness would give rise to a deduction for tax purposes. This provision effectively avoids taxability of the tort, warranty and rent claims mentioned above, whether or not those claims are truly indebtedness. The wording of this provision is significant; since no income is realized, the discharge has no effect on other tax attributes.
And under IRC sec. 102 almost every type of true gift creates no gross income to the recipient. The IRC sec. 102 exclusion is clearly broad enough to encompass cancellation of an obligation, at least in a non-business context.
Is the Adjustment to the Obligation Discharge of Indebtedness?
Discharge of Indebtedness Description
If a liability seems to be indebtedness of the taxpayer for tax purposes, and no special provision renders our particular adjustment of that indebtedness unquestionably non-taxable, the next step in our suggested analytical framework is the determination of the potential taxability of that adjustment. More specifically, the next step in our framework is determination whether our liability adjustment is properly characterized either as discharge of indebtedness which might be included in gross income as IRC sec. 108 COD or as an IRC sec. 1001 amount realized on a sale or exchange.
While IRC sec. 108(d)(1) provides at least a partial definition of indebtedness, the IRC provides no definition of discharge of indebtedness. The American Bar Association suggests a two-part test to identify potentially taxable debt discharge:
- whether at the inception of a loan transaction borrowed funds were excluded from gross income because of an offsetting obligation to repay; and
- if so, whether the taxpayer's obligation to repay has been cancelled, forgiven or reduced.
See American Bar Association Section of Taxation, Report of the Section 108 Real Estate and Partnership Task Force, Part I, 46 Tax Law. 209, 224 (1992).
The ABA test for discharge of indebtedness seems reasonable and readily applicable when the transaction in question is solely cancellation or reduction of a loan repayment obligation. But the characterization of transactions becomes more complex if something of potential value, other than cash, is surrendered in exchange for the debt adjustment. And, as mentioned in our introduction, that is the most common real world situation. Fortunately, however, there is authoritative guidance on the inclusion or exclusion from discharge of indebtedness and its statutory consequences of many of the more common types of exchange transactions involving liability adjustments.
Satisfaction of Indebtedness by Property Transfer
One of the most common exchange transactions involving debt adjustments is the satisfaction of debts with mortgaged property or with other property which the debtor owns. As previously mentioned, a transaction of this type is treated, at least in part, as a sale for tax purposes. Treas. Reg. sec. 1.1001-2(a)(1) states that the amount realized on a disposition of property includes liabilities from which the transferor is discharged as a result of the sale or disposition. Treas. Reg. sec. 1.1001-2(a)(2) then modifies that inclusion in the case of recourse liabilities by excluding any COD from the sale or exchange transaction computation.
Thus, where property subject to recourse debt is disposed of in satisfaction of the debt, and the amount of that debt exceeds the property's fair market value, the IRC sec.1001 regulations effectively bifurcate the transaction. There is sale or exchange gain or loss to the extent of the difference between the fair market value of the property and its basis, and there is COD to the extent of an excess of the debt over the property's fair market value. See Treas. Reg. sec. 1.1001-2(c) Example 8. This position is supported by the courts. See. e.g., Gehl v. Comm., 102 TC 784 (1994), affd 50 F3d 12 (8 Cir. 1995), cert den 616 US 899.
In what seems a counterintuitive twist, however, the regulations under IRC sec. 1001 treat the full amount of any non-recourse debt from which a transferor is discharged as a consequence of disposition of the property which secures it as a sale or exchange amount realized. That position, as reflected in Treas. Reg. sec. 1.1001-2(c) Example 7, prevents treatment of any portion of the debt adjustment as COD. And that position was mandated by the Supreme Court in Comm.v. Tufts, 461 US 300 (1983).
The Tufts decision and resulting IRC sec. 1001 regulations apply only when non-recourse debt is adjusted. In PLR 8918016, the Internal Revenue Service (IRS) took the position that the Bankruptcy Code sec. 506 provision that converts under-secured non-recourse debt to unsecured debt thereby shifts a subsequent adjustment of that converted debt from a sale or exchange amount received to COD. Arguably, therefore, the Tufts rule should never apply to a disposition in bankruptcy.
Furthermore, the Tufts decision and the resulting IRC sec. 1001 regulations apply only if the debtor parts with the debt's collateral security as part of the debt adjustment transaction. Not all adjustments of non-recourse mortgage debt are actually accompanied by disposition of the property securing that debt. Other property of equivalent value can be transferred to the creditor, for example. In that situation, the transaction should be bifurcated between sale or exchange and COD in the same manner as transfers in connection with recourse debt described above.
Satisfaction of Indebtedness Without a Property Transfer
Where there is no disposition of property, there is no sale or exchange. Instead, because IRC sec. 108(d)(1) defines indebtedness for IRC sec. 108 purposes to include indebtedness subject to which a taxpayer holds property, a debt adjustment where the debtor retains the collateral security is treated as COD.
In Rev. Rul. 91-31, 1991-1 CB 19, the IRS confirmed that when a holder of non-recourse debt who was not the seller of the property securing the debt discharges a portion of the debt but does not take the collateral, COD results from the debt modification. The Tax Court has adopted the same rule. See, e.g., Gershkowitz v Comm., 88 T.C. 984 (1987); Carlins v. Comm., T.C. Memo 198-79.
Therefore if, for example, a creditor reduced non-recourse debt to the value of the security in an attempt to assist a workout, without taking the property itself at that time, COD rather than a sale or exchange amount received results from that debt adjustment.
Transfer to Corporations
Corporate indebtedness is sometimes transferred to the debtor corporation, either by an existing shareholder as a contribution to capital or by a creditor in exchange for stock of the corporation.
In addressing the former type of transfer, where no property is actually exchanged for the debt adjustment, IRC sec. 108(e)(6) first withdraws the protection of IRC sec. 118, the IRC section which excludes contributions to its capital from a corporation's gross income. Next, that paragraph treats the corporation as having satisfied its indebtedness with an amount of money equal to the shareholder's adjusted basis in the indebtedness. Corporate COD is potentially created, equal to the difference between the face amount of the indebtedness and the stockholder's basis in that debt.
The latter type of transfer is actually just another form of debt adjustment in exchange for non-collateral property. And, consistent with the exchange treatment discussed above, IRC sec. 108(e)(8) treats the debtor corporation as satisfying its indebtedness with an amount of money equal to the fair market value of the issued stock. If that fair market value is less than the amount of the debt, as is quite likely in workout and bankruptcy situations, COD is created in the amount of the difference.
A brief summary of the theory and procedure for valuation of interests in business entities is attached as an appendix to these materials. As can been readily seen from that summary, the valuation of stock interests in troubled companies can be quite complex.
Because of this, the IRC sec. 108(e)(8) COD measurement rule presents a potential problem. But, because of the mechanics of business entity interest valuation, particularly the applicability of discounts, it also presents a still more significant potential opportunity.
Modification of Terms of Indebtedness
If the terms of a debt instrument are significantly modified, for federal income tax purposes there is a deemed exchange of the old debt for a new debt instrument. Under IRC sec 108(e)(10)(A), the debtor is viewed as satisfying the old debt with an amount of money equal to the issue price of the new debt. IRC sec. 1273(b)(3) sets the issue price of a debt instrument, where either the old or the new obligation is publicly traded, at the fair market value of the publicly traded instrument.
If neither the old nor the new debt is publicly traded, under IRC sec. 1274(a) the issue price of the new debt is its stated principal amount, unless the new instrument bears no interest or below market interest. In the event of inadequate stated interest, the issue price is determined by discounting all payments due under the new instrument at the applicable federal rate. These rules may reduce the issue price of the new instrument below its stated principal amount and cause the debtor to realize COD on the deemed exchange (discussed below under “Deemed Issuance of a New Obligation”). Issue price also affects the creditor’s gain or loss on the exchange (also discussed below under “Deemed Issuance of a New Obligation”).
Deemed Issuance of a New Obligation
Unless specifically exempted, most material modifications to nonpublicly traded debt instruments are subject to IRC sec. 1274 and are viewed as a deemed issuance of a new obligation in exchange for the old debt. Under IRC sec. 108(e)(10)(A), the debtor realizes COD to the extent the principal amount of the old debt exceeds the issue price of the new debt.
In general, under Treas. Reg. sec. 1.1001-1(a) and sec.1.1274-2(a), the creditor also realizes gain or loss on its deemed disposition of the old debt, measured by the difference between the issue price of the new debt and the creditor’s adjusted tax basis in the old debt. Under IRC sec. 1273(a)(1), any excess of the stated redemption price at maturity of the new instrument over its issue price is original issue discount (discussed below under “Original Issue Discount”).
The exceptions to IRC sec. 1274 are:
- Assumptions or acquisitions of debt not considered to contain a significant modification (discussed below under “Modification as Deemed Exchange”);
- Debt instruments with adequate stated interest and no original issue discount;
- Debt instruments publicly traded or issued for publicly traded property;
- Sales of farms for $1 million or less by individuals or small businesses;
- Sales of principal residences;
- Sales of property involving total payments of $250,000 or less;
- Certain land transfers between related persons; and
- Other exceptions.
Original Issue Discount
The original issue discount (OID) rules under IRC sec. 1272 and 1273 require that OID on a debt instrument (i.e., the excess of the instrument’s stated redemption price at maturity over its issue price) be reported as interest income by the creditor over the instrument’s term on a constant interest basis.
The stated redemption price at maturity of a debt instrument is defined by Treas. Reg. sec. 1.1273-1(b) as the total of all payments provided by the instrument other than qualified stated interest payments.
Treas. Reg. sec. 1.1272(b) and 1.1272(c) provide guidance for the computation of the issue price. If the new instrument provides for adequate stated interest, the issue price equals the stated principal amount. In the absence of adequate stated interest, the issue price equals the imputed principal amount. A debt instrument provides adequate stated interest only if the stated principal amount is less than or equal to its imputed principal amount. The imputed principal amount of a debt instrument is the sum of the present values of all payments (including stated interest) due under the instrument, determined as of the date of the deemed exchange.
A de minimis exception to the OID rules is available under IRC sec. 1273(a)(3) if the OID is less than ¼ of 1% of the stated redemption price at maturity, multiplied by the number of full years from the issue date to maturity.
Modification as Deemed Exchange
For IRC sec. 1274 purposes, there is a deemed exchange of old debt for new if the terms of the original debt instrument are changed “materially either in kind or in extent,” within the meaning of Treas. Reg. sec. 1.1001-1(a). Treas. Reg. sec. 1.1001-3, generally referred to as the “Cottage Savings “ regulations, generally adopts a two-step test: does the change constitute a “modification”; and, if so, is the modification “significant?”
Treas. Reg. sec. 1.1001-3(c)(1) defines a debt modification as an alteration of a legal right or obligation of the holder or the issuer, including the addition or deletion of a right or obligation. Generally, if an alteration of a legal right or obligation occurs by operation of the terms of the debt instrument, it is not a modification.
Some examples of modifications are changes in recourse nature or obligor. A debtor’s failure to perform and a debtor’s exercise of a right to convert from a variable to a fixed rate are not modifications.
Assuming that a modification has taken place, the parties must next determine whether it is “significant”. Unless a special rule applies, this is a facts and circumstances test. The general rule of the regulations is that a modification is significant if the legal rights or obligations being changed and the degree to which they are being changed are economically significant.
Examples of significant modifications are:
- Substitution of collateral securing a recourse note (if it results in a change in payment expectations);
- Change in interest rate (if it is by more than the greater of ¼ of 1%, or 5% of the annual yield of the unmodified instrument);
- Extensions of maturity date (if it results in a material deferral of scheduled payments);
- Change from recourse to nonrecourse, or from nonrecourse to recourse; and
- Change from debt to equity.
A substitution of collateral if the collateral is fungible in a nonrecourse note is not a significant modification.
Acquisition of Debt by Related Parties
Under IRC sec. 108(e)(4), the purchase of debt from an unrelated creditor by an entity related to the debtor is treated, for federal tax purposes, as the purchase of debt by the debtor. As a result, COD generally cannot be avoided by having a party related to the debtor acquire the debtor’s debt at a discount from a creditor. Related persons include controlled partnerships, as set forth in IRC sec. 707(b)(1), or individuals or entities treated as related under IRC sec. 267(b).
The IRS has issued regulations to eliminate certain planning possibilities such as the formation of an unrelated entity to purchase debt followed by an acquisition of that entity by the debtor. The regulations provide that COD can arise in either a direct or an indirect acquisition.
A direct acquisition, covered by Treas. Reg. sec. 1.108-2(b), is one where a person currently related to the debtor acquires the indebtedness from a person not related to the debtor.
Under Treas. Reg. sec. 1.108-2(c), an indirect acquisition is one where a person holding the indebtedness becomes related to the debtor, provided that the holder acquired the indebtedness in anticipation of becoming related to the debtor.
Treas. Reg. sec. 1.108-2(c)(e) provides that if the holder acquires the indebtedness less than six months before the date when the holder becomes related to the debtor, the indebtedness is presumed to have been acquired in anticipation of becoming related to the debtor.
If the debt is held for more than six months before the relationship between the debtor and debt holder is established, Treas. Reg. sec. 1.108-2(c)(2) calls for examination of all relevant facts and circumstances in determining whether the debt was acquired in anticipation of the relationship. Specific facts which are to be considered include, but are not limited to:
- the intent of the parties at the time of the acquisition;
- the nature of any contacts between the parties (or their affiliates) before the acquisition;
- The period of time that the holder has held the indebtedness; and
- The significance of the indebtedness in proportion to the total assets of the holder group.
The absence of any discussions between the debtor and the holder (or their affiliates) does not by itself establish that the holder did not acquire the indebtedness in anticipation of becoming related to the debtor.
Under Treas. Reg. sec. 1.108-2(e), the direct/indirect acquisition of indebtedness rules do not apply in the following cases:
- acquisition by a dealer in the ordinary course of its business (i.e., a securities dealer); and acquires the indebtedness.
- acquisition of indebtedness with a stated maturity date that is within one year of the acquisition date, if the debt is, in fact, retired by its stated maturity date.
Amount of COD Income Realized
If either a direct or indirect acquisition occurs, the debtor has COD on the date the acquisition occurs under Treas. Reg. sec. 1.108-2(f). If the holder purchased the debt within the six months proceeding the acquisition date, COD is equal to the difference between the adjusted issue price of the debt and the related holder’s basis in the debt. If the holder did not purchase the debt within the six months proceeding the acquisition date, the debtor’s COD is measured by referring to the fair market value of the indebtedness (rather than the basis) on the acquisition date.
Deemed Issuance Rule
If the debtor realized COD in a direct or indirect acquisition, under Treas. Reg. 1.108-2(g)(1) there is a deemed issuance of new debt for the old debt, and the new debt is deemed issued with an issue price equal to the amount used to compute the debtor’s COD (i.e., either the holder’s adjusted basis or the fair market value of the indebtedness). Any excess of the stated redemption price of the deemed new debt at maturity over its deemed issue price is OID under IRC sec. 1273(a)(2), which is deductible by the debtor and includible in income by the holder to the extent provided in IRC sec. 163 and 1272.
If Discharge of Indebtedness Exists, Can the Tax Consequences Be Avoided or Deferred?
Once it is determined that a debt adjustment is properly characterized as discharge of indebtedness, the next step in our suggested analytical framework is a determination whether provisions exist which will permit avoidance or deferral of potentially undesirable tax consequences.
If a seller of property reduces debt of the purchaser which arose out of the purchase of the property, IRC sec. 108(e)(5) converts the debt discharge to a purchase price adjustment. This paragraph is available only to solvent debtors which are not in Title 11 cases, however.
As mentioned above, Tufts v. Comm. and Treas. Reg. sec. 1.1001-2(c) Example 7 require that the full amount of any non-recourse debt from which a transferor is discharged as a consequence of disposition of the property which secures it be treated as a sale or exchange amount realized.
That rule could prove beneficial for solvent individual taxpayers. The COD portion of any debt adjustment is normally taxable at ordinary income tax rates. The sale or exchange portion, on the other hand, is potentially eligible for preferential long-term capital gain tax rates. And even solvent corporate taxpayers, which lack a preferential capital gain tax rate, have some reasons for preference of capital gain over ordinary income.
For financially insecure or bankrupt taxpayers, however, the IRC sec. 1001 regulations effectively impose a harsher treatment on the discharge of debts for which the taxpayer has no personal liability than they do on the adjustment of debts which the taxpayer actually owes. This anomaly arises because of a series of special COD tax relief provisions in IRC sec. 108(a)(1).
That IRC subsection lists four situations in which COD may be excluded from gross income for tax purposes. Subject to numerous other rules and requirements, that exclusion may occur if:
- the discharge occurs in a Title 11 case;
- the discharge occurs when the taxpayer is insolvent;
- the discharged debt is qualified farm indebtedness; or
- the discharged debt is qualified real property business indebtedness.
Taxpayers utilizing the IRC sec. 108(a)(1) exclusions may pay no tax on COD, but those exclusions are of no benefit if their entire debt adjustment is taxed under IRC sec. 1001 as an amount received on a sale or exchange. The regulation treatment is only mandated in its own fact pattern, however, and as discussed above, the regulation's effects can often be avoided with proper planning.
Taxable gain or loss does not necessarily result if discharge of indebtedness is found to be an amount realized on a sale or exchange. As mentioned above, under IRC sec. 1001 any such amount realized must first be reduced by the adjusted basis of the property disposed of in computing potentially taxable gain. And sale or exchange transactions do not always result in gain. Basis often exceeds the amount realized, resulting in a deductible loss. When that occurs, there is a strong possibility that IRC sec. 1231 will permit ordinary, rather than capital, treatment of the loss.
Are There Costs to Any Available Tax Avoidance or Deferral?
If provisions are identified which will permit avoidance or deferral of the potential tax consequences of discharge of indebtedness, the next step in our suggested analytical framework is identification of any potential costs for those tax benefits.
And when COD is excluded from gross income under IRC sec. 108(a)(1), there are potential prices. In some cases, IRC sec. 108(b)(2) requires an offsetting reduction of certain unused beneficial tax attributes, including most losses and credits as well as property basis. IRC sec. 108(b)(3) requires reduction of any losses at the rate of one dollar of loss for each dollar of excluded COD. Because tax credits reduce the actual tax liability, rather than merely taxable income, that paragraph requires credit reduction of only 33-1/3 cents for each dollar of excluded income.
Can Any Tax Avoidance or Deferral Costs Themselves Be Avoided?
If potential costs for any tax avoidance or deferral are identified, the final step in the tax portion of our suggested analytical framework is identification of potential ways to avoid those costs.
Under the terms of IRC sec. 108(b)(4), any required attribute reductions occur after determination of the tax liability for the year of the excluded debt discharge. Because of this timing rule, any beneficial tax attributes which can be utilized in the discharge year escape IRC sec. 108(b) reduction.
Moreover, there are two significant exceptions to the IRC sec. 108(b) attribute reduction requirements.
First, in the case of reductions in property basis, other than elective reductions under IRC sec. 108(b)(5), IRC sec. 1017(b)(2) limits the required basis reduction to the excess of the taxpayer's aggregate property basis over its aggregate liabilities immediately after the debt discharge. There is also a potentially significant limitation to this exception, however, which represents a trap for the unwary. Treas. Reg. sec. 1.1017-1(b)(3) provides that aggregate liabilities must be reduced by the amount of any cash on hand in computing the statutory exception.
Second, there will clearly be situations where the amount of an insolvent taxpayer's COD exceeds its tax attributes subject to reduction. That excess permanently escapes taxation. See S. Rep. No. 135, 96th Cong., 2d Sess. 13 (1980); H.R. Rep. No. 833, 96th Cong. 2d Sess. 11 (1980).
Impairment or Disposal of Long-lived Assets
Sometimes, particularly when taxpayers are attempting to demonstrate insolvency for income tax purposes, they pay too little attention to the effects which their assertions concerning asset value may have for financial reporting purposes.
Occasionally, changes in operating conditions raise doubts about a company’s ability to fully recover the carrying value of a particular long-lived asset. Statement of Financial Accounting Standard (SFAS) No. 144, Accounting for the Impairment of Long-Lived Assets, provides guidance on the recognition and measurement of an impairment loss for financial statement purposes.
SFAS No. 144 applies to long-lived assets, including capital leases of lessees, long-lived assets of lessors subject to operating leases, and long-term prepaid assets. It does not apply to goodwill, intangible assets not being amortized, financial instruments, deferred policy acquisition costs, or deferred tax assets. The Statement separately addresses long-lived assets to be held and used, and long-lived assets to be disposed of.
Long-lived Assets to Be Held and Used (or Held for Disposal Other than by Sale)
SFAS No. 144 provides two thresholds that must be met before it requires recognition of an impairment loss on long-lived assets to be held and used (or held for disposal other than by sale). First, the entity must assess whether there have been any events or changes in circumstances that indicate that the carrying amount of the long-lived asset may not be recoverable. A financially troubled business is likely to face these conditions.
If the threshold conditions exist, then the entity must assess whether the asset is impaired. This is done by estimating the future cash flows expected to directly result from the asset’s use and eventual disposition. If that amount is less than the asset’s carrying value, then the entity must recognize asset impairment loss.
The amount of impairment loss to be recognized is measured as the excess of the long-lived asset’s carrying amount over the asset’s fair value. Note that a different method is used here – an undiscounted cash flows measure determines whether there is impairment versus fair value measures the amount of impairment. Only if the undiscounted cash flows threshold is met does the company need to measure and recognize the amount of impairment.
SFAS states that quoted market prices in active markets should be used to determine fair value, if such prices are available. If they are not available, the “the best information available” should be used, considering prices for assets and available valuation techniques.
Once an impairment loss is recognized, the adjusted carrying amount becomes the new cost basis that is depreciated over the asset’s remaining life. SFAS No. 144 prohibits any restoration of previously recognized impairment losses.
The previous paragraphs apply primarily to individual assets. However, a company usually will have a group of long-lived assets producing cash flows. SFAS No. 144 requires that, in testing for and measuring impairment, assets “be grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets”.
In the case of a group of assets, the remaining useful life of the asset group should be based on the remaining useful life of the group’s primary asset. The primary asset is the principal tangible long-lived asset being depreciated or intangible asset being amortized that is the most significant component asset from which the asset group derives its cash flow generating capacity. If the primary asset does not have the longest remaining useful life in the asset group, then estimates of future cash flows for the group should assume that the group will be sold at the end of the primary asset’s remaining useful life.
Long-lived Assets to Be Disposed of by Sale
A financially troubled company may have a plan to dispose of long-lived assets by sale to reduce losses and regain profitability. SFAS No. 144 states that these assets should be measured at the lower of their carrying value or fair value less the cost to sell. These assets should not be depreciated and should be presented separately on the balance sheet.
An impairment loss should be recorded for a write-down to fair value less cost to sell. A gain should be recorded for any subsequent increase in fair value less cost to sell, but the gain should not be greater than the cumulative loss previously recognized for a write-down to fair value less cost to sell.
Impairment of Goodwill and Other Intangible Assets
Prior to the issuance of SFAS No. 142, Goodwill and Other Intangible Assets, goodwill was amortized over a maximum of 40 years for financial statement purposes in accordance with APB Opinion No. 17, Intangible Assets. SFAS No. 142 prohibits the amortization of goodwill, and instead requires a test for impairment at least annually.
Testing goodwill for impairment is a two-step process. The first step is to determine whether impairment exists. If the carrying value of goodwill exceeds its fair value, the goodwill is considered impaired and the second step of the impairment process is applicable.
The second step of the impairment process is the measurement of the amount of the impairment loss. The loss is the amount by which the carrying value exceeds the implied fair value. However, the loss cannot exceed the carrying value of the goodwill and recognized impairment losses may not be subsequently reversed.
SFAS No. 142 also applies a similar testing process to intangible assets with indefinite useful lives.