TAX ISSUES IN - PDF document

1 TAX ISSUES IN RESTRUCTURING TROUBLED P
TAX ISSUES IN RESTRUCTURING TROUBLED PARTNERSHIPS AND CORPORATIONS Tax Group Bracewell LLP 2016 2 TOPICS • Cancellation of Indebtedness Income • Partnership Debt for Equity Exchange ‒ Consequences to the Debtor Partnership and its Partners ‒ Consequences to the Creditors • Corporation Debt for Equity exchange ‒ Tax Considerations of the Corporation ‒ Tax Considerations of the Creditors • Debt for Debt Exchanges and Debt Modifications 3 I. CANCELLATION OF INDEBTEDNESS INCOME • A taxpayer recognizes cancellation of Indebtedness Income (“CODI”) when an indebtedness of the taxpayer is discharged or satisf

2 ied at a discount. ‒ CODI is gener
ied at a discount. ‒ CODI is generally equal to excess of (i) the outstanding balance of the debt, over (ii) the value of the consideration paid, if any, to satisfy the debt. ‒ CODI is excluded from gross income if, among other things, o the discharge occurs in bankruptcy, or o the discharge occurs when the debtor is insolvent. ‒ Any CODI excluded from gross income will be applied to reduce the tax attributes of the taxpayer. 4 I. CANCELLATION OF INDEBTEDNESS INCOME (CONT’D) • CODI is triggered when a person related to the debtor acquires the outstanding indebtedness. Related persons are, among other things ‒ Members of a family;

3 ‒ An individual and a corporation mo
‒ An individual and a corporation more than 50% in value of the outstanding stock of which is owned, directly or indirectly, by such individual; ‒ A partnership and a person owning, directly or indirectly, more than 50% of the capital or profits interest in such partnership; ‒ Two corporations in a controlled group (50% ownership); ‒ A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation, and more than 50% of the capita or profits interest in the partnership; ‒ Two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital or profits in

4 terest. 5 II. PARTNERSHIP DEBT FO
terest. 5 II. PARTNERSHIP DEBT FOR EQUITY EXCHANGE -- CONSEQUENCES TO DEBTOR PARTNERSHIP AND ITS PARTNERS • CODI in the Partnership Debt for Equity Exchange. ‒ CODI is equal to the excess of (i) the outstanding balance of the debt over (ii) the fair market value of the partnership capital or profits interest issued to the creditors in satisfaction of the debt. ‒ CODI is allocated to the partners in the partnership immediately before the exchange/discharge of partnership debt. ‒ CODI may be excluded if the individual partner is insolvent or in bankruptcy – the insolvency/bankruptcy test is applied at the individual partner level, no

5 t the partnership level. 6 I
t the partnership level. 6 II. PARTNERSHIP DEBT FOR EQUITY EXCHANGE – CONSEQUENCES TO DEBTOR PARTNERSHIP AND ITS PARTNERS (CONT’D) • Determination of Fair Market Value of Partnership Capital or Profits Interest ‒ Generally, all facts and circumstances are considered in determining fair market value ‒ Liquidation value safe harbor: the fair market value of the partnership capital or profits interest is deemed to be equal to the liquidation value of the equity interest, if the following conditions are satisfied o Each creditor, the debtor partnership, and its partners consistently treat the liquidation value as the fair market val

6 ue; o The terms of the exchange are co
ue; o The terms of the exchange are comparable to terms that would be agreed to by unrelated parties negotiating with adverse interests; and o Subsequent to the debt for equity exchange, the debtor partnership does not redeem the equity interest, and no person related to the debtor partnership or its partners purchases the equity interest, as part of a plan at the time of the exchange that has as a principal purpose the avoidance of CODI by the debtor partnership. ‒ Definition of liquidation value. o Liquidation value equals the amount of cash that the creditor would receive with respect to the equity interest received if, immediately after the excha

7 nge, the partnership sold all of its ass
nge, the partnership sold all of its assets for cash equal to the fair market value of those assets and then liquidated. 7 III. PARTNERSHIP DEBT FOR EQUITY EXCHANGE – CONSEQUENCES TO CREDITORS • Creditors do not receive any corresponding losses. ‒ Creditors are treated as contributing the partnership debt to the partnership in exchange for the partnership equity interest in a tax - free contribution transaction described in Section 721. o No losses are recognized. Creditors receive a high basis in the partnership equity equal to its basis in the debt obligation. o Character conversion: Loss ultimately will be recognized when creditors

8 subsequently sell their partnership in
subsequently sell their partnership interest with a high basis. But such loss generally would be capital loss, while a bad debt deduction generally would be ordinary loss. 8 III. PARTNERSHIP DEBT FOR EQUITY EXCHANGE – CONSEQUENCES TO CREDITORS (CONT’D). • Creditors have to recognize ordinary income for unpaid rents, royalties and interests. ‒ The tax free treatment does not apply to transfer of a partnership interest to a creditor in satisfaction of a partnership’s indebtedness for unpaid rent, royalties, or interest (including OID). o The partnership equity interest transferred in satisfaction of any unpaid rent, royalties or int

9 erest (including OID) accrued on or afte
erest (including OID) accrued on or after the beginning of the creditor’s holding period for the indebtedness is taxable to the creditors as ordinary income. o The debtor partnership will not recognize any gain or loss upon the transfer of a partnership interest to a creditor for unpaid rent, royalties, or interest. 9 III. PARTNERSHIP DEBT FOR EQUITY EXCHANGE – CONSEQUENCES TO CREDITORS (CONT’D). • Creditors Tax Planning ‒ Partial worthless debt deduction o Non - security trade or business debt. o Has to be in “a transaction independent of and separate from the debt - for - equity exchange”. ‒ Worthless security deduction

10 ‒ Existing partner contributes partn
‒ Existing partner contributes partnership debt for equity o Authority in the corporate context ensures there would be no CODI income to the corporation in this case. o No similar authority in the partnership context – 108(e) on its face requires partnership to recognize CODI between the excess of the face amount of the debt over the fair market value of the debt. o Documenting the transaction as contributing the cash equal to the debt to the partnership and then the partnership pays down the debt in full. 10 III. PARTNERSHIP DEBT FOR EQUITY EXCHANGE – CONSEQUENCES TO CREDITORS (CONT’D). • Creditor Tax Planning ‒ A sale of the

11 debt to a third party before the debt f
debt to a third party before the debt for equity exchange ‒ A significant modification of the debt (which is treated as a taxable exchange for tax purposes) before the equity for exchange ‒ Section 743(b) adjustment 11 IV. CORPORATION DEBT FOR EQUITY EXCHANGE – TAX CONSIDERATIONS OF THE CORPORATION • CODI calculation. • Exceptions for CODI ‒ Two exceptions on CODI inclusion for companies in financial distress. Gross income does not include any amount which would be includible in gross income by reason of the discharge of indebtedness of the taxpayer o bankruptcy exception: if the discharge occurs in a title 11 case (i.e. ban

12 kruptcy). o insolvency exception: if
kruptcy). o insolvency exception: if the discharge occurs when the taxpayer is insolvent. » The tern “insolvent” means the excess of liabilities over the fair market value of assets, determined immediately before the discharge. » The amount of CODI excluded shall not exceed the amount by which the taxpayer is insolvent. 12 IV. CORPORATION DEBT FOR EQUITY EXCHANGE – TAX CONSIDERATIONS OF THE CORPORATION (CONT’D) • Reduction of Tax Attributes ‒ The amount of CODI excluded from gross income must be applied to reduce the tax attributes of the taxpayer in the following order, unless an election is made. o Net operating losses

13 o General business tax credits o Min
o General business tax credits o Minimum tax credits o Capital losses o Basis in the assets o Passive activity losses and credits o Foreign tax credits ‒ The taxpayer may make an election to first reduce the basis in the depreciable property. ‒ Amount of reduction o Other than tax credits, the reduction is one dollar for each dollar of CODI excluded o For tax credits, the reduction is 33 1/3 cents for each dollar of CODI excluded ‒ Timing of reduction o The reduction is made after the determination of the tax for the taxable year of the discharge. 13 T: E: CONTACT Vivian Ouyang Senior Counsel +1.212.938.6406 vivian

14 .ouyang@bracewelllaw.com This presenta
.ouyang@bracewelllaw.com This presentation is provided for informational purposes only and should not be considered specific legal advice on any subject matter. You should contact your attorney to obtain advice with respect to any particular issue or problem. The content of this presentation contains general information and may not reflect current legal developments, verdicts or settlements. Use of and access to this presentation does not create an attorney - client relationship between you and Bracewell. CONTACT Vivian Ouyang Senior Counsel +1.212.938.6406 vivian.ouyang@bracewell.com TAX ISSUES IN RESTRUCTURING TROUBLED PARTNERSHIPS AND CORPORATIONS T