Economic Stimulus Legislation Provides Income Tax Deferral Of Certain Cancellation Of Indebtedness Income
The new law just signed by the President contains a provision that is designed to facilitate debt workouts in today’s difficult economic environment. Income arising from business debt workouts, from reacquisitions of business debt by borrowers or borrower-related entities and from business debt write downs or write offs may now be deferred, and recognized beginning in 2014.
Generally speaking, income called cancellation of indebtedness income (CODI) results when indebtedness is discharged for less than its face amount, when indebtedness is reduced as part of a consensual workout where the borrower retains the property that secured the debt, or when indebtedness is acquired at a discount by the borrower or by a person or entity that is related to the borrower. CODI may arise when a borrower issues an equity interest (shares of stock or interests in a partnership or an LLC, for example) to a lender in satisfaction of all or a portion of indebtedness held by a lender or when the lender contributes indebtedness to the capital of the borrower. The potential for CODI is present in connection with foreclosures, friendly or otherwise, of recourse indebtedness.
The tax law contains several ways to avoid CODI. For instance, non-C corporation taxpayers can elect to exclude CODI relating to discharges or reductions of so-called qualified real property indebtedness. Also, corporate or human taxpayers that are insolvent or in bankruptcy may avoid CODI. Generally speaking, though, there is a price to be paid by a taxpayer who desires to sidestep the recognition of CODI. The price is that the taxpayer must reduce certain of its tax attributes. These tax attributes include its tax basis (frequently, depreciable) in property and certain types of credits, losses and associated carryovers. When CODI is triggered on indebtedness associated with real property, most often the price to be paid is a one dollar basis reduction in the taxpayer’s direct or indirect interests in depreciable real property for each dollar of CODI excluded. A collateral consequence of this basis reduction is that most of the extra gain recognized when the property whose basis was reduced is sold often ends up being taxed as ordinary income.
The 2009 economic stimulus legislation adds a new elective CODI bypass for business indebtedness worked out, discharged, acquired by the borrower (or a related person), exchanged by the lender for equity interests in the borrower or contributed by the lender to the capital of the borrower during calendar years 2009 or 2010. CODI that would otherwise have been recognized currently is deferred and recognized ratably over the 5-year period beginning roughly in 2014 and ending roughly in 2018.
The good news is that there’s no attribute reduction associated with the new law and no additional ordinary income recapture potential when assets whose depreciable basis would otherwise have been reduced are sold.
The bad news is that the law provides that the election is to be made by the borrower entity. Why is that bad? In the real estate world, borrowers are frequently entities that are treated as pass thru entities for income tax purposes or that are single-member LLCs whose sole member is such a pass thru entity for income tax purposes. Although the pass thru entity would make the election to have the new law apply, the tax consequences of that decision would be determined at the ultimate taxpaying (C corporation or human being, typically) beneficial ownership level.
Different taxpayers might be in different taxpaying situations. Because of his particular tax-driven desires and objectives, one taxpayer who owns real estate that is subject to qualified real property business indebtedness through a pass thru entity might be willing to suffer attribute reduction and to deal with the potential ordinary income recapture in order to completely avoid CODI from a particular discharge. His partner might be in a different tax situation and unwilling to do that. Once the election is made under the new law for a particular discharge, the other potential exceptions (insolvency, bankruptcy, qualified real property business indebtedness, etc.) become unavailable for that discharge.
What’s the general partner or the managing member of the borrower entity to do when faced with conflicting tax interests of the partners or members? Perhaps there will be a technical correction to the law. Until and unless that happens, though, loan workouts that might otherwise have gone forward because of the palliative provisions of the new law might stall. Admittedly, the new law does contain a broad delegation of authority to the Treasury Secretary to prescribe regulations that are necessary or appropriate to apply the rules, including “rules for the application of [the provision] to partnerships, S corporations, and other pass thru entities”. However, it is doubtful that even this broad a delegation of authority would permit regulations to change a rule contained in the statute itself. It is also possible that the Congress and the Treasury Department might not view as problematic the position of conflict in which a general partner or a managing member might find itself.
We anticipate, however, that in many instances the partners’ or members’ tax interests will be aligned and that making the election under the new law will be an easy decision. The tax breathing room resulting from CODI deferral until 2014 might just be enough to enable many more loans to be worked out this year and next.
If a borrower/tax partnership elects to have the new provision apply, the CODI deferred by the election must be allocated to the partners who were partners in the partnership immediately before the discharge in the same manner as the CODI income would have been allocated to them if the election hadn’t been made. What exactly the specific language of the new law means here and how it will be applied in concert with usual partnership tax accounting rules are far from clear. The new law does contain useful technical language that attempts to coordinate the application of the CODI deferral mechanism with certain other provisions of partnership tax law so that the deferral objective isn’t undone by technical foot faults. Furthermore, CODI deferred under the new provision will be triggered if certain partnership changes or adjustments occur in the future but before all the CODI is picked up into income, including for example a sale, exchange or redemption by or of a partner in the partnership/borrower that made the CODI deferral election. How these provisions are to be applied in practice is likely to be the subject of regulatory guidance.
One final note for California taxpayers: California doesn’t automatically incorporate Federal changes to the tax law. Consequently, this new Federal provision will not apply to California income taxes until and unless the California legislature passes conforming tax legislation.
The foregoing is a discussion of general interest only. It is not intended to constitute income tax advice or to be a substitute for careful tax planning under the guidance of a tax professional. Further, it is not intended or written to be used, and it cannot be used, by anyone for the purpose of: (i) avoiding penalties that may be imposed under United States federal tax laws; or (ii) promoting, marketing or recommending to another party any transaction or matter described herein.
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