Watch Out for These Debt Modification Tax Issues

The IRS has made it clear that debt cancellations generally result in taxable income. When taxpayers are relieved from the legal obligation to pay back a loan, they must recognize and pay taxes on that cancellation of debt (COD) as if it were income unless the law specifically exempts that transaction. COD income can arise when loans are forgiven or when they are settled for less than fair market value, but simply restructuring debt can also trigger COD income recognition.

Taxable debt restructurings can take many forms. Modifying key terms (like changing interest rates or payback period), making a stock-for-debt exchange, or selling publicly-traded debt to a related party are simple tweaks that can trigger income tax consequences for the borrower. Understanding COD income recognition rules is especially important right now, because debt restructurings have become commonplace during the coronavirus pandemic. With much of the economy still operating at a limited capacity, organizations are feeling the crunch and many are having a difficult time servicing their debt. If your organization has made changes to its debt agreements recently, it should be mindful that debt modification tax issues may arise.

Why Debt Modification Tax Issues Are Increasing

The Coronavirus Aid, Relief, and Economic Security (CARES) Act signed into law on March 27, 2020 has been a life saver for many borrowers because it offers financial aid in the form of stimulus payments and low or no-interest loans. Many organizations may have been unable to pursue loans or loan forgiveness under the CARES Act, however, for various reasons due to the loan terms (e.g., size of the business, employee retention rules, and allocation of funds).

In these circumstances, organizations may have asked their lenders for relief from late payment penalties. But the disruption from the COVID-19 pandemic is far from over, which may mean that additional steps will be needed to alleviate issues with servicing debt. Your organization may need to renegotiate loan agreements altogether. In some instances, COD income can be difficult to avoid with renegotiated loan agreements, and borrowers will need to regard COD income as an additional cost of the new loan.

What is COD Income?

Most forms of debt forgiveness are considered COD income, with few exceptions. COD income is not always taxable, however. When debt is cancelled in a Chapter 11 bankruptcy, or when debt that exceeds the fair market value of the company’s assets is cancelled, taxpayers may still have COD income to report; however, those amounts can be excluded from gross income, ultimately making them nontaxable.

Debt forgiveness may be common under COVID-19, but organizations are much more likely to recognize COD income from debt modifications.

Debt Modifications

The modification or restructuring of existing debt may result in taxable COD income even though the debt was not forgiven outright. For instance, borrowers may ask for temporary relief from foreclosures or collection efforts if they make late debt payments. That type of modification should not be considered COD income if the forbearance is granted for a period no longer than two years. But this nontaxable treatment only goes so far. When creditors implicitly or explicitly defer interest and principal payments, the IRS may classify the revised arrangement as a “significant” debt modification, and treat it instead as a taxable exchange of a debt instrument. The IRS will determine the materiality of the change by looking at all the facts and circumstances, but the only way for taxpayers to guarantee a tax-free modification is if they qualify for the IRS’s safe harbor.

To qualify for the safe harbor, the taxpayer must make up all deferred payments within a period that begins on the original due date for the first scheduled payment that is deferred, and ends on the earlier of:

Five years later, or

50% of the loan’s original term.

Payment extensions made beyond that timeline may still qualify for tax-free treatment, but they must be analyzed further to determine if they represent a significant modification of the debt. Generally, the IRS will view a material deferral of payments as a significant modification of the debt instrument. The regulations provide for tests under which a debt modification needs to be analyzed. The testing criteria include changes in:

• Yield,
• Timing of payments,
• Obligor or security,
• Nature of the debt instrument, or
• Accounting of financial covenants.

There is also a general test reviewing facts and circumstances that may indicate that the legal rights or obligations are altered to a degree that is economically significant.

Where a significant modification of debt has occurred, a new (modified) debt instrument is deemed to have been issued in exchange for the old (unmodified) debt instrument. This is called a debt-for-debt exchange. The debtor realizes COD income to the extent the adjusted issue price of the old debt instrument exceeds the issue price of the deemed new debt instrument.

Publicly and Not Publicly-Traded Debt

Determining if a significant debt modification has occurred will differ if the debt instrument is privately held or publicly traded. Unfortunately, it is not always clear when debt is deemed to be publicly traded.

In 2012, the IRS released regulations which provide that property (including debt instruments) is publicly traded if, at any time during the 31-day period ending 15 days after the loan’s issue date, the property has:

• A sales price determined from an actual trade, or
• One or more firm or indicative quotes from a broker.

The one exception to this rule is for small debt issuances. Debts with outstanding principal balances of $100 million or less at the time of the deemed debt-for-debt transaction will not be considered publicly traded, and will be taxed as if the exchange was of two private debt instruments.

The tax consequences of a debt instrument’s status as publicly traded are two-fold. First, there are more circumstances involving modifications that result in COD income than those involving private debt. Second, modifications that result in a new debt instrument may carry an original issue discount (OID).

Organizations that modify publicly traded debt instruments are more likely to recognize COD income because the IRS defines a significant modification differently for each. When an organization retires publicly traded debt and purchases new debt, the IRS will deem there to be a significant modification of the debt instrument if the debt is trading below its market value. The market values of privately held debts are not under the same scrutiny.

Similarly, when organizations purchase publicly-traded debt that is trading at a discount from a related party, the debtor may also need to recognize COD income.

When publicly traded debt instruments have been significantly modified, the borrower will recognize COD income at the time of the exchange and, to the extent OID exists, will recognize OID over the life of the loan. As is the case with qualified stated interest, OID interest is subject to the business interest limitation that was introduced by the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA). Since 2018, business interest expense deductions have been severely limited, and although the CARES Act eased up on this limitation for the time being, many businesses may never be able to deduct those expenses, which include OID. Let’s look at a significant debt modification example where OID is present:

Company holds $100,000 of publicly-traded debt, but after the market dips, their debt is only valued at $90,000. Because the coronavirus upset their business operations, Company can no longer service this debt. To address their liquidity concerns, their lender agrees to a deferral of interest payments by two years. Although the issue price of the new debt is $100,000, its value reflects that of the old debt ($90,000), which means that the Company recognizes COD of $10,000 and the new debt is issued with OID of $10,000.

Cash Flow Considerations Related to the Tax Impact of COD Tax Treatment

COD income is considered ordinary income for tax purposes, which means pass-through borrowers will owe taxes based on their highest marginal tax rates, rather than the more favorable capital gains rates. Additonally, the forgiven amount is taxable even if the business replaces that loan with new debt. And because COD income is taxable in the year the debt is discharged, organizations may be challenged by the associated tax liability while staying current on new debt payments.

Unused net operating losses (NOLs) can help to shelter current tax liabilities, and thanks to CARES Act changes, NOLs from 2018, 2019, and 2020 can be carried back for up to five years to offset prior tax liabilities as well. To the extent NOLs are available to shelter the impact of COD income in the current year, they can remove some of the burden associated with taxable COD income, but losing valuable tax attributes to renegotiate debt can be a difficult pill to swallow.

Final Thoughts

Cancellation of debt is a particularly relevant subject right now since so many organizations are entering into debt negotiations with their lenders. Borrowers would be wise to consult an expert when negotiations are in process. If they can structure debt modifications with taxes in mind, they can avoid COD income when possible and plan for additional taxes when COD income cannot be avoided.

For additional questions about this issue, please contact us.