In this difficult economic climate many businesses are over-burdened by debt and are considering various alternatives to satisfy their debt for less than the amount initially borrowed. Some businesses are restructuring the debt to reduce the loan amount outstanding and the amount of monthly payments. Others are entering into agreements with their lenders for a reduced lump-sum pay-off amount to satisfy the loan. In cases where the loan is secured by property (for example, an apartment building), some lenders are agreeing to take the property, though valued at less than the loan amount, in complete satisfaction of the loan.
When working with lenders to reduce debt, it is important to be aware of the tax consequences. Generally, where debt is fully or partially canceled or forgiven by the lender, the amount of the canceled debt is taxable to the borrower as ordinary income. The purpose of this article is to describe the general tax consequences in connection with the frequently-used debt reduction alternatives mentioned above, as well as the more common exceptions to the inclusion of the canceled indebtedness income.
Cancellation of Indebtedness Income
The fundamental principle being enforced by treating the cancellation of indebtedness as income is that there has been an “accession to wealth” by the borrower. The initial loan amount was received by the borrower tax-free because of the requirement that it be repaid. When all or a portion of the loan amount is forgiven, theoretically an equivalent amount of the borrower’s assets is then available for other purposes (i.e., no longer required for repayment of the debt); and the borrower is better off financially. The additional assets theoretically made available to the borrower by the canceled indebtedness constitute the accession to wealth.
When borrowers work out an overall reduction in the principal amount of a loan and a reduced monthly payment, the discounted principal amount (and any interest which is also forgiven) is canceled indebtedness and ordinary income to the borrower, unless an exception applies. For example, assume X Corporation has $1,000,000 remaining on its loan from Y Bank and X Corporation is unable to make full payments on the loan due to the business downturn. If Y Bank agrees to forgive half of the loan amount and to reduce the principal balance of the loan to $500,000, X Corporation will have $500,000 of canceled indebtedness income for the year the cancellation occurs, unless an exception applies.
Similarly, when borrowers and lenders agree that the loan will be satisfied by payment of a lump-sum amount which is less than the balance due, the forgiven amount (principal and interest) constitutes canceled indebtedness income for the borrower, unless an exception applies. For example, assume A, an individual, owes $750,000 on his business line of credit with D Bank but, due to the business downturn, is unable to make payments. D Bank agrees that, if A makes a lump-sum payment of $250,000, D will release A from the remaining balance on the loan. If A makes the payment and is released from the remaining amount, A will have $500,000 of canceled indebtedness income for the year the cancellation occurs, unless an exception applies.
In those cases where the loan for which the borrower is personally liable is secured by property and the lender agrees to take the property, though valued at less than the amount owed on the loan, in full satisfaction of the loan, there are two distinct tax calculations that need to be made. First, the transfer of the property to the lender is treated for tax purposes as a sale of such property by the borrower to the lender for a price equal to the property’s fair market value. Taxable gain or loss in connection with such deemed sale will be equal to the difference between the property’s fair market value and its remaining cost basis. The characterization of the gain or loss on the deemed sale as capital or ordinary will generally depend upon the purpose for which the property was held. Second, the difference between the loan amount and the property’s value is canceled indebtedness and ordinary income to the borrower, unless an exception applies.
For example, Z Corporation has an outstanding loan of $1,500,000 from W Bank for which Z Corporation is personally liable that is secured by an apartment building owned by Z Corporation with a fair market value of $800,000. Z Corporation has a remaining cost basis of $1,000,000 in the apartment building. Due to the business downturn, Z Corporation is unable to make payments on the loan and W Bank agrees to take the apartment building in satisfaction of all amounts due under the loan. If Z Corporation transfers title to the apartment building to W Bank in satisfaction of the loan, the transfer will be treated as a deemed sale of the apartment building by Z Corporation to W Bank for the building’s fair market value of $800,000, resulting in a loss to Z Corporation of $200,000 ($1,000,000 basis less $800,000 deemed sales price), which will be characterized as capital or ordinary generally depending upon the holding purpose of the property. Additionally, Z Corporation will have $700,000 of canceled indebtedness income ($1,500,000 loan amount less $800,000 value of property), unless an exception applies. If the loss is treated as a capital loss, then generally the loss cannot be used to offset the canceled indebtedness income. On the other hand, if the loss is treated as an ordinary loss, the loss could be used to offset in part the canceled indebtedness income.
Treatment of Guarantees
Before turning to the common exceptions to the inclusion of the canceled indebtedness as income, the general treatment of guarantees in connection with the forgiveness or cancellation of indebtedness should be briefly discussed. Frequently in connection with making a business loan, the lender will require that repayment be personally guaranteed by the owner(s) of the business and possibly by related parties as well. The guarantee enables the lender to collect amounts due under the loan from the guarantor in the event the borrower fails to pay. Because a guarantee applies only in the case of a borrower’s default, which may or may not occur, it is considered a “contingent liability.”
The release of a guarantor from its contingent liability by cancelling the guarantee does not result in canceled indebtedness income for the guarantor. Moreover, when a debt is canceled or forgiven by the lender under the scenarios described above and the guarantor is released from its obligations under the guarantee, though the borrower likely has canceled indebtedness income, generally, the guarantor does not. However, in the case where the debt is non-recourse to the borrower and the guarantor becomes liable on the debt upon the borrower’s default, the forgiveness of all or a portion of such debt by the lender could result in canceled indebtedness income for the guarantor.
Exclusion of Cancelled Indebtedness from Income
There are a number of exceptions to the requirement that canceled indebtedness be included in income. Probably the more common exceptions are those involving the forgiveness of indebtedness which occurs: (i) while the borrower is in bankruptcy; (ii) when the borrower is insolvent; (iii) with respect to indebtedness which is “qualified real property business indebtedness”; and (iv) with respect to indebtedness the payment of which would have resulted in a tax deduction.
To the extent the indebtedness cancellation occurs while the borrower is in bankruptcy or while it is insolvent, the exclusion from income is automatic and does not require an affirmative election by the borrower. However, in the case of insolvency, the amount excluded is limited by the extent to which the borrower is insolvent (i.e., by the amount the borrower’s liabilities exceed the value of its assets). When canceled indebtedness income is excluded by the bankruptcy or insolvency exceptions, the amount excluded must be applied to reduce certain tax attributes of the borrower. For example, if the borrower has net operating losses for the year in which the cancellation occurs (or a net operating loss carry-over to such year), the excluded canceled indebtedness income must be applied to reduce such net operating losses. However, if the borrower owns depreciable property with basis remaining, the borrower can elect to apply any portion of the excluded canceled indebtedness income first to reduce the basis (to the extent of such basis) of such depreciable property.
In those cases where a borrower (who is not in bankruptcy or insolvent) obtains a loan which is “qualified real property business indebtedness,” then the borrower (so long as it is not a C corporation for income tax purposes) may elect to exclude from income the amount of such loan which is canceled. “Qualified real property business indebtedness” is basically indebtedness incurred or assumed by the borrower to acquire, construct, reconstruct or substantially improve real property used in a trade or business where the indebtedness is secured by such real property, and the borrower elects to treat it as “qualified real property business indebtedness.” The amount of canceled indebtedness income excluded under this exception must be applied to reduce the borrower’s basis in its depreciable real property. There are several limitations to the amount a borrower can exclude under this exception. First, the borrower may not exclude more than the amount by which the outstanding principal amount of such indebtedness (before cancellation) exceeds the fair market value of the real property in connection with which the indebtedness was incurred or assumed as described above (with such value reduced by the amount of any other indebtedness which is “qualified real property business indebtedness” and secured by such real property). Additionally, the amount excludable under this exception cannot exceed the available basis of depreciable real property owned by the borrower.
Generally, the cancellation of indebtedness does not result in income to the extent that payment of the liability would have entitled the borrower to take a deduction for such payment. For example, if interest due under a business loan of a cash-basis borrower is canceled, the amount of such canceled interest does not result in income, because the interest when paid would have been deductible by the borrower as a business expense. On the other hand, if interest due under a business loan of an accrual-basis borrower is canceled, the amount of such canceled interest does result in income, because the interest when paid would not have been deductible by the borrower (as the interest was deductible as it accrued). In other words, where the canceled indebtedness represents an expense for which the borrower has enjoyed the benefit of a deduction, then such cancellation results in income. However, no income results where such canceled indebtedness represents an expense that has not yet been deducted (but would be deductible when paid), as the borrower has not yet enjoyed the benefit of such deduction.
A borrower may be able to utilize more than one exception. In such case, the application of the exclusions must be coordinated. The bankruptcy exclusion takes precedence over the other exceptions, and the insolvency exception takes precedence over the qualified real property business indebtedness exception.
Deferral of Income Inclusion
The American Recovery and Reinvestment Act of 2009 added a new tax provision that allows a business to elect to defer canceled indebtedness income realized in connection with the reacquisition of an applicable debt instrument after December 31, 2008 and before January 1, 2011.
Generally, an “applicable debt instrument” is one issued by (i) a C corporation or (ii) any other person in connection with the conduct of a trade or business by such person, and “reacquisition” means any acquisition by the borrower (or a related person) of the debt instrument, including an acquisition of the debt instrument for cash or other property, the exchange of the debt instrument for another debt instrument, the exchange of the debt instrument for equity, the contribution of the debt instrument to capital and the complete forgiveness of the debt instrument by the lender.
In such case where the election to defer under this provision is made (the IRS has published guidance on making the election), income from indebtedness canceled in connection with a reacquisition in 2009 and/or 2010 generally is includible in the income of the borrower ratably over five years beginning in 2014. However, by taking advantage of this deferral election, among other things, the borrower becomes ineligible for the bankruptcy, insolvency or qualified real property business indebtedness exceptions described above with respect to such canceled indebtedness income. Additionally, the borrower takes on the risk that income tax rates may be higher when the canceled indebtedness income must be included in the borrower’s taxable income.
Final Thoughts
Many businesses today face difficult choices in restructuring their debtload. In this process, it is important to keep in mind that each of such restructuring options has tax consequences based on the cancellation of indebtedness income rules that must be weighed and evaluated as part of the restructuring plan. There are some exceptions to inclusion of canceled indebtedness income and deferral opportunities; but they, too, have consequences that must be considered.
This article is only intended as a general discussion of the tax consequences from cancellation of indebtedness in some of the more common debt reduction scenarios. There are many complexities to these rules that are beyond the scope of this article (for example, the application of the rules in the case of partnerships and S corporations). Because tax consequences to different taxpayers may differ substantially based on the specific facts of the case, it is important that each taxpayer obtains professional tax advice in evaluating the tax consequences of forgiveness of indebtedness.
This article is intended to provide general information and should not be relied upon as a substitute for legal or tax advice from an experienced tax advisor who has carefully considered your particular facts and circumstances. Information contained herein was neither intended nor written to be used and cannot be used for the purpose of avoiding tax penalties that may be imposed under the Internal Revenue Code or for promoting, marketing or recommending to another party any matters addressed in this article.