Taxes issues in bankruptcy.

1. Tax Implications of Debt
Restructuring, Debt
Forgiveness, and
Bankruptcy
27th Annual Real Estate Institute
Joel A. Lebewitz
Thomas G. Wallrich
Steven A. Silton

2. I. SEMINAR TOPICS
A. DEBT RESTRUCTURING AND CODI
1. Types of Debt Restructuring - (Not Exhaustive)
2. Tax Consequences of Debt Restructuring
3. Cancellation of Indebtedness Income (“CODI”)
a. CODI – Tax Treatment to Debtor
b. CODI – Tax Treatment to Issuer – OID v. Market Discount
c. CODI – Tax Treatment to Third Party – Purchase of Debt at
Discount by Third Party
4. CODI Deferral Election under “ARRTA”
5. Debt for Debt Exchange
6. Issue Price and the meaning of “Publicly Traded”
7. Significant Modification and the Deemed Exchange
8. Modification of Debt to Equity

3. B. CHANGE OF OWNERSHIP OR CONTROL AND
LOSS CORPORATIONS
1. Section 382 Basics
2. Section 382 Generally
3. What is Equity Under Section 382
4. NOL Poison Pills
5. Section 382 Limitations Value
a. Adjustment to Value
b. Calculation of the Section 382 Limitation
6. Successive Ownership Changes and the Section 382
Limitation
7. Section 382 in Bankruptcy

4. II. CONCLUSION

5. A. DEBT RESTRUCTING AND CODI
1. Types of Debt Restructuring
 Repurchase or settlement of debt by issuer for
cash or other property (Including stock)
 Actual exchange of old debt for new debt with
significantly modified terms
 Significant modification of old debt (deemed
exchange)
 Purchase of old debt by “related party” of issuer
(deemed exchange)
 “Related party” – described in §267(b) or 707(b)(1); attribution rules
apply

6. 2. Tax Consequences of Debt Restructuring
Borrower
 COD income if and to extent face value of old debt is
greater than cash, FMV of property, or issue price of
new/modified debt given in settlement
 Possible OID deductions over term of new/modified debt
Holder
 Taxable vs tax-free
 Generally capital gain or loss (loss may not be recognizable)
 Possible OID (ordinary) income inclusions over term of
new/modified debt
 No OID if/to extent basis is > amounts payable (other than
qualified stated interest) and > issue price

7. 3. Cancellation of Indebtedness Income
(“CODI”)
 How to measure – Two Types
 Debt issues with OID
 Debt issues without OID
 Character of income
 Traditional exceptions to recognition of CODI
 Bankruptcy
 Insolvency
 Contribution to capital
 No more debt for equity exclusion (including equity of partnerships)
 Modifications Authorized Under Rev. Proc. 2009-45 (Attached)
 ARRTA Deferral (Below)

8. 3(a). CODI - Tax Treatment to Debtor
 Immediately taxable to debtor if no exclusion
applies; Debtor may (mostly) offset with available
NOLs
 Exclusion for bankruptcy, insolvency, or non-
corporate qualified real property indebtedness:
reduce tax attributes (NOLs, asset basis – subject
to “liability stop”) by amount of COD (§ 108(a),
(b))
 Elect to defer COD income under American
Recovery and Reinvestment Tax Act of 2009 (Pub.
L. No. 111-5) (“ARRTA”) (Principal IRC provisions:
§§ 108(i); 163(e)(5)(F)

9. 3 (b). CODI – Tax Treatment to Issuer – OID v.
Market Discount
 Original Issue Discount
 Accrues daily
 Constant yield basis
 Taken into income currently
 Generally deductible by issuer (subject to AHYDO and certain
related party timing rules)
 Market Discount
 Accrued market discount generally treated as interest income
 Accrues daily
 Ratable basis unless elect constant yield
 Only taken into income only payment or sale
 Not deductible by issuer

10. 3 (c). CODI – Tax Treatment to Third Party –
Purchase of Debt at Discount by Related Party
 CODI recognized as though issuer repurchased
 Traditional exceptions to CODI available
 Election to defer CODI
 Deemed reissuance of note from issuer to related
party
 Effectively converts market discount to OID

11. 4. COD Deferral Election Under ARRTA
 American Recovery and Reinvestment Tax Act of
2009 (“ARRTA”) (Pub. L. No. 111-5)
 Implicates IRC §§ 108(i) and 163(e)(5)(F)
 Debtor can elect to defer COD income on 1009 or
2010 reacquisitions of an “applicable debt
instrument” (§ 108(i)(4)(B):
 Buy-back of debt for cash by issuer/related party
 Actual (or deemed) exchange of debt for debt of issuer
or related party
 Defer OID deduction to extent defer CODI inclusion
 Exchange of debt for stock or partnership interest
 Contribution of debt to capital
 Complete forgiveness of debt

12. 5. Debt for Debt Exchange
5(a). Non-Taxable
 Debts securities – Tax-free recap
 No gain or loss
 Boot includes excess principal amount on new debt
 CODI not gain, so can have CODI
 Depending on issue price (discussed below), new debt
can have OID
 One debt not security – Fully taxable

13. 5(b). Taxable
 CODI where issue price of new debt is less than
adjusted issue price of old debt
 Holder may recognize gain or loss
 Amount realized deemed equal to issue price of new
debt

14. 6. Issue Price and the Meaning of “Publicly
Traded”
 “Issue price”
 Publicly traded debt – Fair market value
 Nonpublicly traded – Face value if adequate stated interest
 Current depressed market prices for publicly traded
debt likely cause COD on debt exchanges even if
new debt face equals old debt face
 “Publicly traded” is broadly construed:
 Listed on exchange or interdealer quotation system,
 Traded on board of trade or interbank market,
 Appears in system of general circulation (including by
subscription) providing reasonable basis for determining FMV,
or
 Readably quotable price from dealers, brokers, or traders
 Syndicated bank debt can be considered publicly
traded!

15. 7. Significant Modification and the Deemed
Exchange
 “Economically significant” alterations) of legal
rights/obligations
 Safe harbor: customary accounting/financial covenant changes
 What is covered? Lack of authority; covenant waivers risky
 Deemed exchange likely is:
 Change in yield of greater than 25 bps or 5% of existing yield
 Count fees/interest paid to lenders for amendment/forbearance
 Deferral of payment (e.g. beyond lesser of 5 yrs or 50% of
original term)
 Change in obligor, credit support, or priority
 Possibly requiring “change in payment expectations”
 From “primarily speculative” to “adequate” or vice versa
 Change from recourse to nonrecourse
 Change from debt to equity

16. 8. Modification of Debt to Equity
 Modification resulting in “non-debt” is “significant”
 Mere deterioration in ability to pay not taken into
account in determining if modification results in
“non-debt,” unless change in obligors in
connection with modification
 Section 382 effect

17. B. CHANGE OF OWNERSHIP OR
CONTROL AND LOSS CORPORATIONS
1. Section 382 Basics
 Limits a “loss corporation”
 That undergoes an “ownership change”
 An ownership change occurs if immediately after an owner
shift or an equity structure shift – The percentage by value of
stock of the loss corporation owned by one or more 5-percent
shareholders has increased by more than 50 percentage
points over the lowest percentage ownership of such
shareholders
 During a 3-year “testing period”
 From utilizing “pre-change losses” or other tax
attributes

18. 2. Section 382
 Loss Corporation
 NOL, tax credit, capital loss, or other attribute carryforward
 Net Unrealized Built-In Loss (“NUBIL”)
 Testing Period
 Begins on the first day of the tax year when carryforward
begins
 3-year “rolling” period unless change occurs

19. 3. What is Equity Under 382
What generally counts as “equity” when
determining a Section 382 ownership
change?
 Common voting stock
 Convertible preferred stock
 Voting preferred stock

20. 4. NOL Poison Pills
Protect your NOLs with a NOL poison pill plan
 Shareholder rights plans deter new 5% shareholders
 Can prohibit existing shareholders from buying more
without board approval
 Board can waive
 Watch out – Selectica, Inc. v. Versata Enterprises, Inc.,
No. 4241-VCN (Del. Ch. January 3, 2009)

21. 5. Section 382 Limitation Value
 Does not include any new investment being
made on the change value
 Value of pure preferred (1504(a)(4) stock) is
included in the limitation calculation
 Even though not tracked for equity shifts
 Market capitalization of a public company may be
the starting point
 Does a control premium matter? See TAM 200513027

22.  5 (a). Adjustments to Value
Holding “substantial nonbusiness assets” (1/3 of total
asset value) immediately after the ownership change
 May be required to back out value of capital
contributions made within 2 years of ownership change
if they are pursuant to a plan
 Annual limitation may become zero if continuity of
business enterprise is violated within 2 years of change
 A loss group is treated as a single entity for this test
 Need at least one member loss group member to continue business
 Corporate contractions
 PLR 200406027 no corporate contraction where target
guaranteed debt

23. 5(b). Calculation of the Section 382 Limitation
Section 382 Limitation Example:
 Value immediately before change $1,820
 Capital Contributions pursuant to plan ($200)
 Adjusted value $1,620
 Published rate (L.T. tax exempt) 5.00%
 Annual NOL Limitation $81
 Annual limitation accrues, even if unused

24. 6. Successive Ownership Changes
 If two or more successive ownership changes,
then each Section 382 limitation is applied
independently (Reg. Section 1.382-5(d)
 Later ownership changes may result in a lower, but not a
higher, Section 382 limitation
 Application of rule may result in layers of NOLs where
each layer is subject to different limitations
 A single low limitation can trap prior NOLs, and
subsequent limitations can not create a higher limitation
for previously limited NOLs

25. 7. Section 382 in Bankruptcy
7(a). Special Rules
 Assuming that the loss corporation has NOLs and
other attributes that survive attribute reduction
under Section 108(b), Section 382 will likely
apply to the utilization of losses post bankruptcy
 Consider the impact of an election under Section
108(b)(5)
 382(1)(5) – generally provides for no limitation
on use of NOLs if certain requirements are met
 382(1)(6) – generally provides for increased
limitation if certain requirements are met
 (1)(6) is applicable if requirements for (1)(5) are not
met or if debtor elects out of (1)(5)

26. 7(b). Section 382 in Bankruptcy - 382(1)(5)
 In title 11 immediately before the change
 Continuity of interest (tests pre-change
shareholders and “qualified creditors”)
 Post bankruptcy former creditors or historic shareholders
must hold greater than 50% of the vote and value
 Special option rules for determining ownership that may
have retroactive effect
 Example: options or warrants exercised by creditors and
historic shareholders within three years of emergence
from bankruptcy could allow a loss corporation to qualify
for Section 382(1)(5) benefits back to the emergence
from bankruptcy

27. 7©. Section 382 in Bankruptcy
382(1)(5) Effects and Consequences
 The use of pre-change losses is not subject to limitation under
Section 382
 If another ownership change occurs within 2 years, the Section
382 limitation with respect to the second ownership change will be
zero
 Interest haircut:
 NOLs & excess credits are reduced by:
 Interest on the debt converted into equity in the bankruptcy proceeding
(interest haircut) that was paid or accrued in:
 Any taxable year ending during the three-year period preceding the
taxable year in which the ownership change occurs, and
 The period of the taxable year in which the ownership change occurs on
or before the change date
 CCA 200915033 – (1)(5) not available for “pre-packaged
bankruptcy”

28. 7(d). Section 382 in Bankruptcy
Example:
 A loss corporation enters bankruptcy with $500M
in NOL
 $300M of debt is cancelled and the creditors
receive $100M worth of equity
 $50M of interest was incurred on the converted
debt during the look back period
 $200M of COD is excluded, none of which relates
to accrued interest on the converted debt
 The NOLs are reduced to $250M ($500-$200-$50)

29. 7(e). Section 382 in Bankruptcy - 382(1)(6)
 Certain tax-free reorganizations; or
 Title 11 case; and
 382(1)(5) doesn’t apply
 Must continue the business for 2 years following
the change date or the 382 limitation is 0

30. 7(f). Section 382 in Bankruptcy
382(1)(6) Effects
 382 limit applies
 Limitation is based on enhanced value following
surrender or cancellation of creditor’s claims
 Interest haircut does not apply

31. 7(g). Section 382 in Bankruptcy
Choosing between (1)(5) and (1)(6)
 Compare amount of NOLs
 Compare amount of COD income
 Interest haircut
 Comfort the transaction will qualify under (1)(5)
 Application of Notice 2003-65
 Future plans
 Ownership change
 Continuing the business
 May want to modify bylaws/charter to prevent sales for 2 years