Mark Lubin's article, “Pitfalls Associated with Troubled Businesses,” in PICPA’s CPA Now
Reprinted with permission from CPA Now, the blog of the Pennsylvania Institute of Certified Public Accountants.
Pitfalls Associated with Troubled Businesses
By Mark L. Lubin, CPA, JD, LLM
Business downturns tend to be cyclical. When they occur, even sophisticated tax practitioners face pressure to quickly reacquaint themselves with issues they haven’t confronted recently. This blog highlights some of the many potential exposures concerning distressed businesses.
Debt Workouts, Modifications, and Cancellations
Most practitioners are aware that a cancellation of debt generally results in taxable cancellation of indebtedness income (COI), absent bankruptcy or insolvency.1 Moreover, “significant” modifications of debt trigger deemed exchanges that can result in tax consequences to debtors and creditors.2 Broadly speaking, changes in a debt instrument’s legal terms constitutes a modification, and modifications will be considered significant if they – cumulatively with other modifications – have a significant economic impact. Changes in obligor, interest rate, or security are typically significant modifications.
Debt modifications and cancellations can lead to unexpected tax results. A few examples include the following:
- Acquisitions of debt by a party related to the debtor (such as by purchase at a discount) can trigger COI.3
- Debt exchanged for the debtor’s stock, debt-for-debt exchanges, and contributions of debt to the debtor’s capital generally have differing tax consequences.4
- Modifications of certain corporate obligations can result in onerous tax consequences under the “applicable high-yield debt obligation” rules.5
- Where COI is excluded, tax attributes such as loss and credit carryforwards and the basis of property held by the debtor must generally be reduced.6
- Complicated issues can arise where the debtor is a partnership. For example, modifications can change the amounts of debt allocated under Internal Revenue Code (IRC) Section 752 to respective partners, resulting in deemed distributions and potential gain recognition. Also, the COI bankruptcy and insolvency exceptions generally apply at the partner (rather than partnership) level.7
Moreover, foreclosures and other property transfers in settlement of debt can have varying consequences, depending on whether the debt is recourse or nonrecourse in nature, the value of the property, and the balance of the debt.8
Net operating losses can generally be carried forward indefinitely and used to offset 80% of taxable income (determined with modifications).9 However, IRC Section 382 limits the use of C corporation loss carryovers following an “ownership change,” which is generally an ownership increase of more than 50 percentage points by any combination of 5% shareholders within a three-year testing period.10 Section 382 practice is rife with pitfalls, including the following considerations:
- Failure to maintain adequate records regarding direct and indirect ownership can prevent corporations and their advisers from proving that an ownership change hasn’t occurred and preclude opportunities to structurally avoid ownership changes.
- Significant “built-in losses” at the time of an ownership change are generally subject to limitation, and the recognition of significant “built-in gains” can generally increase the Section 382 limitation.11 Taxpayers have the burden of proving the existence and amounts of built-in gains and the lack of built-in losses. Thus, failure to establish basis and the value of loss in corporation assets held at the time of an ownership change can have adverse consequences.
- Special rules under Section 382 apply in bankruptcy situations.12 Those rules broadly reflect the economic reality that debtholders are often the stakeholders in a corporation where its equity value has been wiped out.
- Multiple ownership changes, and situations where business activity of a loss corporation is discontinued, can have harsh results from a loss carryforward perspective.
Bad Debts and Worthless Stock
The Internal Revenue Code provides deductions for worthless stock and bad debts.13 These deductions raise factual questions on which taxpayers have the burden of proof. Both areas present pitfalls, such as the following:
- Deductions can be available for partly worthless (only partially recoverable) business bad debts, whereas nonbusiness bad debts must be completely worthless to be deductible (and the deduction is treated as a capital loss). Thus, it can be important to develop factual evidence to support characterization of a receivable as business-related.
- Debts evidenced by bonds or other securities are generally deductible under general rules concerning property losses, rather than as bad debts.14 That can result in capital loss treatment.
- A worthless stock deduction requires proof both that the stock had value at the beginning of the relevant tax year (i.e., that it had not previously become worthless) and that it had no value at the end of the year. Evidence of identifiable events causing worthlessness is often critical to establishing the deduction, and vigilance should be exercised to claim it for the first taxable year in which worthlessness can be established.
Personal Liability for Business Taxes
Business entities are required to collect certain taxes imposed on other taxpayers. For example, they are typically required to withhold income and employment taxes imposed on their employees, and they are required to collect sales taxes from customers to whom they sell property or provide certain services. Where such a business falls into distress, there can be a strong temptation to “temporarily” use collected taxes for other purposes, such as to meet payroll or pay other expenses. Although rules vary by jurisdiction and tax, these situations can present a huge pitfall because personal liability can result to owners, managers, and other parties that have control or some degree of responsibility over business affairs.15 Even where such liability ultimately is found not to apply, the time and cost required to defend these cases can have a devastating impact on clients and advisers.
 IRC Section 108(a). The insolvency exception applies only to the extent of the debtor’s insolvency. Other exceptions to COI apply in certain situations involving cancellations of farm or real property indebtedness or student loans.
2 Treas. Reg. 1.1001-3.
3 IRC Section 108(e)(4).
4 Compare IRC Section 108(e)(6), (8), and (10).
5 See IRC Section 163(e)(5) and (i). Those issues can often be avoided by limiting the remaining term to five years.
6 IRC Section 108(b), which prescribes an ordering rule regarding such reduction and an election to reduce depreciable property basis before reducing other attributes.
7 IRC Section 108(d)(6).
8 See, e.g., Treas. Reg. Sec. 1.1001-2(c), Examples 7 and 8, and Com’r v. Tufts, 461 U.S. 300 (1983).
9 See generally IRC Section 172(a)(2) and (b)(2). Unused credits can also generally be carried forward.
10 IRC Section 382(g). Section 383 imposes similar limits regarding certain credits and capital loss carryovers, and Section 384 restricts the use of certain preacquisition losses against “built-in” gains.
1 IRC Section 382(h).
2 IRC Section 385(l)(5) generally has a favorable impact in those situations, but an election out of Section 385(l)(5) can be made, in which event the Section 382 limitation will often be increased under Section 385(l)(6).
3 IRC Sections 165 and 166.
4 IRC Sections 166(e).
5 See e.g., IRC Section 6672.
Mark L. Lubin, CPA, JD, LLM, is special counsel at the law firm Chamberlain Hrdlicka in Philadelphia, where his practice focuses on tax planning and complex business transactions. He can be reached at firstname.lastname@example.org.