As the authors stated in the series email from Monday, April 27, 2020, titled “Debtor Tax Considerations of Debt Restructuring”, many businesses are already finding it difficult, if not impossible, to service their debt obligations. As a result, many businesses are seeking to modify or restructure their debt, or, in more extreme cases, to have all or a portion of their debt forgiven or discharged. As discussed therein, restructuring transactions that result in the reduction or elimination of indebtedness can give rise to income – in the nature of: (i) “cancellation of indebtedness income” (“CODI”); and/or (ii) gain (or loss) depending on a variety of facts/circumstances. As noted therein, the rules and laws that govern debt restructurings are very complex. These issues can become even more complicated to the extent such events occur with respect to the liabilities of a pass-through debtor, such as a limited liability company, limited partnership or S corporation. Today we will highlight some of the nuances that should be considered in connection with debt restructurings involving such pass-through entities.
To the extent that CODI will be realized by a pass-through entity in connection with a debt restructuring, the first issue to consider is whether the debtor that realizes the CODI is treated as a partnership (i.e., most limited partnerships and limited liability companies) or an S corporation for federal tax purposes. If the debtor is taxed as a partnership for federal tax purposes, the debtor must allocate its income and/or gain (loss) among its partners as provided in the applicable partnership/limited liability company agreement or as otherwise required by law. The laws that affect how these allocations may be required to be made are often quite complex and depend on a number of factors that are beyond the scope of this summary. Nevertheless, it is important to understand that the basic income and loss allocations in an operating agreement applicable to an entity treated as a partnership for federal tax purposes may not always be respected when allocating CODI and/or may be overridden by more specific partnership allocation rules (such as the minimum gain chargeback provisions). The allocation rules relating to CODI are much less complex in connection with a debtor that is treated as an S corporation for federal tax purposes.
To the extent that CODI will be realized by a pass-through entity in connection with a debt restructuring, the next issue to consider is the potential application of certain of the exceptions/limitations (i.e., bankruptcy, insolvency, etc.) relating to the recognition of CODI by the debtor and/or its partners/members/shareholders. Specifically, to the extent that one of these exceptions/limitations apply, all or a portion of the CODI realized in connection with a restructuring may not have to be recognized for federal tax purposes. To the surprise of many people, these exceptions/limitations are applied completely differently for pass-through debtors treated as partnerships for federal tax purposes as opposed to those treated as S corporations for federal tax purposes. Specifically, in analyzing the applicability of these exceptions/limitations with respect to a debtor treated as a partnership for federal tax purposes, such analysis is determined at the partner/member level (i.e., the determination of whether the bankruptcy or insolvency exception is applicable depends on whether the restructuring occurs while the applicable partner/member is in bankruptcy or is insolvent, as the case may be). In contrast, in analyzing the applicability of these exceptions/limitations (i.e., bankruptcy, insolvency etc.) with respect to a debtor treated as an S corporation for federal tax purposes, such analysis is determined solely at the debtor level (i.e., the determination of whether the bankruptcy or insolvency exception is applicable depends on whether the restructuring occurs while the debtor S corporation, itself, is in bankruptcy or is insolvent, as applicable). Based on the foregoing, in connection with a debt restructuring transaction involving an insolvent or bankrupt partnership or limited liability company (but the partners or members of which are neither insolvent or in bankruptcy), it may be advisable to consider the possibility of making an election to treat the partnership or limited liability company as an S corporation or C corporation for federal tax purposes. Of course, a number of factors/issues would need to be considered prior to making any such election. In any case, it is important to understand that to the extent that the bankruptcy or insolvency exception is utilized by an S corporation debtor or by the partners or members of a debtor treated as a partnership for federal tax purposes, to exclude or limit the recognition of CODI, certain tax attributes (for example, net operating losses, tax basis in assets, etc.) of the applicable taxpayer generally will be subject to reduction. These attribute reduction rules are beyond the scope of this summary but may be addressed in a future email.
In addition to the foregoing, in light of the various rules, requirements and consequences relating to the CODI exceptions/limitations noted above (i.e., bankruptcy, insolvency etc.), it is worth noting that certain planning opportunities may exist to intentionally trigger the realization of CODI versus gain (loss) or vice versa in connection with a debt restructuring. The authors previously touched on certain of the factors/issues relevant to this analysis in the April 27 email noted above. One key factor in any such determination is whether the applicable indebtedness is recourse or nonrecourse in nature. This determination would appear to be a fairly straightforward analysis, with the nature of the debt generally being determined at the pass-through entity level (as opposed to the partner/member/shareholder level). However, based on at least one Tax Court decision, there may be some authority (although recent IRS administrative guidance further calls this into question) for a limited liability company debtor, taxed as a partnership for federal tax purposes, to take the position that an applicable restructuring transaction results in gain (or loss) rather than CODI, or vice versa, based on the characterization of the debt as recourse or nonrecourse at the member level instead of at the entity level (which may be preferable because, for example, the applicable members are not themselves in bankruptcy or insolvent). To the extent that a member of a limited liability company could benefit from such result, further consideration of the case law (and the subsequent IRS administrative guidance) may be warranted.
Finally, as noted in a number of the prior emails constituting part of this educational series, a debt restructuring transaction may in certain cases have the effect of reducing the amount of partnership/limited liability company debt that is allocated to a specific partner/member under Code Section 752 and the Treasury regulations thereunder. The effect of this reduction can be quite significant. Specifically, any such reduction will be treated for federal tax purposes as a deemed distribution of cash to an applicable partner/member. Depending on the applicable partner’s/member’s tax basis in the debtor partnership/limited liability company, this could trigger gain recognition to such partner/member, and, at the very least, will result in a reduction of such partner’s/member’s tax basis in the applicable entity, thereby potentially reducing such partner’s/member’s ability to deduct certain future losses/deductions allocated to such partner/member by the applicable entity for federal tax purposes. Consideration of these tax consequences is extremely important in connection with any debt restructuring involving a pass-through debtor treated as a partnership for federal tax purposes.
The foregoing is merely intended to identify and highlight some of the basic tax issues and planning opportunities that should be considered by pass-through debtors (and their owners) in connection with a debt restructuring. The authors hope that you and/or your clients find this email informative should a debt restructuring become necessary in connection with your business ventures. If you have follow up questions please feel free to reach out to either of the authors of this email. Until next time, stay safe and have a great week!