The economic outcome from the coronavirus (COVID-19) pandemic is still uncertain but is likely to remain catastrophic in many respects. Of late popular name brands and companies have filed for bankruptcy as stay-at-home orders and social distancing requirements remain largely in effect. Morgan Lewis tax lawyers alert those considering bankruptcy or restructuring to various tax traps that may arise during these processes.
One significant consequence of the COVID-19 pandemic is the disruption to US economy. Those businesses struggling pre-pandemic may not be able to withstand continued stay-at-home orders or social distancing requirements. According to data released by the American Bankruptcy Institute, chapter 11 bankruptcies increased 26% in April 2020 as compared to April 2019. Further as discussed in our previous LawFlash, companies may look to restructuring as a cost-saving measure outside of bankruptcy. Morgan Lewis tax lawyers caution companies contemplating bankruptcy or restructuring to consider the below tax implications of either action.
Forgiveness of Debt May Trigger Taxable Cancellation of Debt Income (CODI)
A debtor that is able to discharge debt at a discount is generally required to include the discharge of indebtedness income or CODI as gross income. As a general matter, CODI is equal to the excess of the outstanding balance of the debt over the consideration paid, if any, on the debt.
IRC § 108 provides circumstances in which CODI is excluded from gross income. Specifically, CODI realized in a chapter 11 bankruptcy case is excluded. Additionally, CODI realized when the taxpayer is insolvent is excluded to the extent of the insolvency. In practice, a taxpayer may have easier path to excluding CODI in bankruptcy rather than prove out insolvency. Importantly, the bankruptcy exception is available to a debtor in bankruptcy even if such debtor is not insolvent. If the debtor is not in bankruptcy, it may still benefit from the insolvency exception, which effectively limits CODI to the extent of the debtor’s insolvency determined immediately prior to the work out or transaction at issue. Any CODI excluded is generally applied to reduce the tax attributes of the debtor.
Although CODI may be a consequence of debt forgiveness, to the extent a taxpayer has significant net operating losses (NOLs) to shelter income, the inclusion of CODI in gross income may not be a material tax issue.
CODI can pose unique issues in the context of taxable partnerships (for example, multi-member LLCs that have not elected to be taxed as corporations). Of particular note, the insolvency and bankruptcy exceptions to CODI apply at the partner level and not the partnership level. The result is that CODI is determined at the partnership level without the possibility of exclusion under these exceptions and then allocated among the partners who each may be able to exclude all or a portion of its allocated CODI based on its individual insolvency or bankruptcy status. How a partnership’s CODI is allocated among its partners, however, may not be entirely clear depending on (1) how the CODI arises (for example, if it is attributable to a so-called “chargeback” of prior debt-funded deductions or losses allocated to the partners under the partnership tax rules) and (2) on the relevant terms addressing allocation of CODI (or lack thereof) in the applicable partnership agreement.
Uncertainty and possible flexibility in how a partnership’s CODI may be allocated among its partners often becomes a significant business issue in partnership workouts and a possible trap for the unwary partner. It is finally worth noting that tax and bankruptcy law practitioners have at times observed a disconnect between the partnership tax rules and the Bankruptcy Code that may create tensions in negotiations of workouts.
In light of the above, debtors are advised to consider the tax consequences of a bankruptcy or other debt workout involving a discharge of debt before engaging in the same.
Taxable Gain Recognition May Result from Work Out Plans or Bankruptcy
Restructuring debt may have unexpected tax consequences. Significant modification of a debt instrument is treated as an exchange of original debt for a new modified debt for tax purposes. To the extent debt is relieved through the exchange the debtor may realize CODI. A number of changes and amendments to a debt instrument are considered a significant modification, sometimes unexpectedly. Such changes include but are not limited to changes in payment terms, changes in obligor or security, addition or removal of co-obligors, changes in payment priority of debt, and changes in the nature of the debt. As noted above, there are various exceptions to CODI that results from a debt workout, notably including exceptions for bankrupt and insolvent taxpayers.
Debtors should beware of any changes to existing debt instruments that may trigger a significant modification and thus potentially a taxable exchange of a debt instrument resulting in (taxable) CODI, depending on the facts. Debtors may be able to take advantage of the bankruptcy or insolvency exceptions to CODI and are encouraged to consider the tax consequences of any debt modification accordingly.
Tax Attributes May Become Limited After a Bankruptcy or Reorganization
Use of NOLs and other tax attributes are limited per IRC § 382 when a corporation experiences an ownership change. An ownership change occurs when any shareholder owning 5% or more of the corporation increases his or her share by more than 50 percentage points as a result of a transaction during a three–year period. Transactions generally include stock acquisitions and corporate reorganizations, including those pursuant to a bankruptcy.
The IRC § 382 limitation is measured as the value of the corporation immediately before the ownership change, which may be as little as zero in the case of a corporation considering bankruptcy or reorganization and thus the corporation may not fully utilize NOLs in a future tax year. Under IRC § 382(l), two special rules similar to the CODI exceptions may apply: one for debtors in bankruptcy and one for debtors that are insolvent. These special rules either prevent application of the NOL limitation or increase the value of the corporation and thereby allow the debtor to retain more NOLs for use. Note, choosing between the two special rules is a binary choice, with some benefits and drawbacks to each special rule. These rules should be carefully reviewed by a debtor before undergoing an ownership change to properly assess any prospective tax attribute use limitation and which option results in best tax optimization.
Most states do not follow the federal NOL rules. Therefore, to the extent a corporation has limited NOL usage on a federal level, a separate analysis is required to determine if and to what extent NOLs are limited for a state return filing. Further, special analysis is required to determine NOL limitations in combined and consolidated reporting states as compared to separate reporting states.
Not All Tax Debts Are Discharged in Bankruptcy
A bankruptcy filing is a tool available to debtors in financial stress. The bankruptcy filing creates an automatic stay on collection activities, including actions by a taxing authority. Further, the automatic stay suspends any tax court proceedings. A bankruptcy court has the ability to determine the amount or legality of any tax, fine, penalty, or addition to tax, even if the tax has not been paid. However, the bankruptcy court cannot determine the amount or legality of a tax, fine, penalty, or addition to tax if the matter was already contested before another court.
Not all tax debts are eligible for discharge. Taxes collected by the taxpayer when acting as an agent for the government are not eligible for discharge. These taxes, called trust taxes, include employee withholding, social security, Medicare, excise taxes, and duties. Further, taxes due for which a return was either not filed or filed late and within two years after filing bankruptcy are not eligible for discharge.
Derivative Tax Liability May Arise Upon Reorganization or Bankruptcy
Unpaid trust tax liabilities that survive the bankruptcy filing or a debt workout often fall into the category of “responsible person liabilities.” This form of derivative liability means that when the corporation fails to pay certain taxes, a responsible person may be held liable for the nonpayment. The IRS uses IRC § 6672 as a mechanism for collecting the unpaid liability by imposing a penalty against “any person required to collect, truthfully account for, and pay over any tax who willfully fails to collect such tax…” “Responsible person” is not defined by statute but in case law has been generally found to be “a high corporate official charged with general control over corporate business affairs who participates in decisions concerning payment of creditors and disbursal of funds.” State taxing authorities use a similar mechanism to collect unpaid trust tax liabilities from persons within the corporation that had the ability or duty to make payments of tax to the state.
For any outstanding taxes not discharged in bankruptcy or as part of a debt workout, corporate officers should strategize payment options so as not to be held personally liable for any unpaid amounts.
Section 363 Sales May Trigger Tax Consequences
Some debtors pursue asset sales under Section 363(b) of the Bankruptcy Code to provide the debtor more control over disposition of its assets than under a Chapter 7 liquidation bankruptcy proceeding. We expect that these so-called “Section 363 Sales” will gain increased traction as companies face insolvency issues. Section 363 Sales by a bankrupt or insolvent corporation may give rise to significant tax issues for both the buyer and seller. With limited exceptions, a transfer of assets by a bankrupt or insolvent corporation is no different than a sale by a solvent company, namely that the determination of whether the sale of tangible and real property will be subject to transfer taxes is determined under state law.
For sales and use tax, states will often have many exemptions that could apply to asset sales, including the resale exemption which would apply to the sale of inventory, to the extent the buyer provides the seller an exemption certificate. Additionally, many states have exemptions for “bulk” sales (sale of substantially all of the assets of a business), and/or occasional sales (sales outside the ordinary course of business), but the requirements for these exemptions vary significantly from state to state, and the end result of these variations is often a narrow application of the exemptions to the transaction. In addition to sales tax, most states, and several localities, impose real estate transfer tax on the sale (and in some cases, the long-term lease) of real property. Another consequence of the sale of real estate is a property tax reassessment.
A bankruptcy-specific issue is that if a sale is pursuant to the confirmation of a chapter 11 plan (and is not a sale under Section 363(b) of the Bankruptcy Code that occurs pre-confirmation), then Section 1146 of the Bankruptcy Code says that the transfer “may not be taxed under any law imposing a stamp tax or similar tax.” This language creates some ambiguity as to whether property transfer and gains taxes would be eligible for exemption, and greater ambiguity as to whether it could apply to sales tax.
Another issue is the income tax consequences of the asset sale to the seller. As an asset sale, there may be taxable gain on the sale. It may be that NOLs can offset the gain (or it may also be that otherwise available NOLs might be better used as a carryback (particularly to tax years when the corporate rate was 35%). Income tax on the sale is an administrative claim, and is generally required to be paid to the extent that there is sufficient cash to pay secured creditors of the debtor.
Finally, an issue resulting in tax consequences to the buyer is the purchase price paid by the buyer (including amounts treated as liabilities for tax purposes) become the tax basis of the acquired assets. In some asset purchases, the portion of the purchase price allocated to accounts receivable and inventory is less than the face amount of accounts receivable and original basis of the inventory, with the result that a subsequent sale of these items would result in substantial gain and increased taxable income.
Debtors considering a bankruptcy, reorganization, or other debt workout may be missing opportunities to obtain much-needed cash through other means. Two examples are described below.
Taxpayers should consider expanded use of NOL carryback rules enacted in the CARES Act when developing plans for restructuring or bankruptcy. Before filing for bankruptcy or enacting a restructuring, taxpayers who were unable to carryback NOLs generated in tax years 2018 and 2019 should consider amending prior year returns to carryback NOLs. Further, the CARES Act suspends the 80% of taxable income limitation on the utilization of NOLs for tax years beginning before 2021. Taxpayers may amend a prior year return to fully offset taxable income with NOLs and thereby claim a refund. Obtaining a refund may outweigh the benefits of a restructuring in some cases by providing a quick cash infusion. More detail regarding the CARES Act amendments to NOL carrybacks is found in our previous Lawflash.
Worthless Stock Loss Deductions
Corporate taxpayers contemplating bankruptcy should consider whether a worthless securities deduction may be available to its shareholders under IRC § 165(g). Whether and when corporate securities become “worthless” during a particular taxable year is ultimately a facts-and-circumstances determination. Generally, regulations and judicial precedent require corporations to be insolvent in the taxable year for which a worthless stock loss deduction is sought by the corporation’s shareholders. Additionally, shareholders must evidence the corporation has no future potential value. This is typically demonstrated by the occurrence of an “identifiable event” permanently fixing the loss. Bankruptcy and liquidations are among the types of events that have been acknowledged as terminating any reasonable expectation of future profitability. Domestic corporations may be eligible for an ordinary loss (rather than a capital loss) under IRC § 165(g)(3) with respect to the worthless securities of a qualifying affiliated subsidiary. The affiliated subsidiary must satisfy an active gross receipts test calculated over the entirety of the subsidiary’s gross receipts history. As noted above, the CARES Act’s expanded NOL usage rules allow taxpayers to amend certain prior year returns to fully offset taxable income with NOLs. An ordinary worthless securities loss under IRC § 165(g)(3) may generate an NOL that can be carried back under these new rules.
As demonstrated above, there are a number of actions in bankruptcy or restructuring that could create unintended tax consequences. Morgan Lewis’s bankruptcy practice works in partnership with its robust tax practice to create tax efficient bankruptcy or restructuring plans. Companies considering bankruptcy or restructuring should reach out to Morgan Lewis lawyers before undertaking any actions.
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If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Kurt A. Mayr
Barton W.S. Bassett
Colleen M. Redden
 U.S. Bankruptcies Fall in April, but Commercial Chapter 11 Filings Rise, Reuters, May 5, 2020.
 Kurt A. Mayr and David L. Lawton, “Bankruptcy During COVID-19: Three Expedited Options” (April 27, 2020).
 During the economic downturn of 2008–2011, the Internal Revenue Service (IRS) allowed taxpayers an election to include CODI income ratably over a five-year period. 26 USC § 108(i)(1). The last two rounds of economic stimulus bills did not include this measure but it could be included in future bills.
 Similarly, the insolvency and bankruptcy CODI exceptions apply at the owner level with respect to disregarded entities (for example, single-member LLCs that have not elected to be taxed as corporations) and grantor trusts.
 A partner’s interest in the partnership, though, may constitute an asset or liability in an insolvency calculation.
 E.g., tax and bankruptcy law practitioners have raised concerns over partnership audit rules, specifically the conflict between partnership representative under the Internal Revenue Code and authority of the Bankruptcy Court under the Bankruptcy Code.
 26 USC § 6672(a).
 Monday v. U.S., 421 F.2d 1210 (7th Cir. 1970).
 Treas. Reg. §§ 1.165-4(a); 1.165-5(b), (c); Morton v. Comm’r, 38 B.T.A. 1270 (1938).
 Morton, 38 B.T.A. at 1278-79.