WORKING OUT AND RESTRUCTURING
DISTRESSED DEBT – TAX TRAPS AND TECHNIQUES
TO ACHIEVE FAVORABLE OUTCOMES
Western District Bankruptcy Bar
October 8, 2009
Richard A. Latta
Michael Best & Friedrich LLP
One South Pinckney Street, Suite 700
Madison, WI 53703
(608) 257-3501
ralatta@michaelbest.com
www.michaelbest.com
© Michael Best & Friedrich LLP 2009
MISSION
To legally reduce to a nominal amount the income tax paid upon
debt and mortgage restructuring, workout or forgiveness of debt
(a/k/a “Cancellation of Debt” or “COD”).
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VISION
Create a toolbox that allows practitioners to address debt and
mortgage restructuring, workout and forgiveness situations.
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WHAT’S THE PROBLEM?
If the bank is willing to restructure the debt and forgive part of it – that’s great!
But –

United States v. Kirby Lumber Co., 284 U.S. 1 (1931) – The U.S. Supreme Court
established the rule that a debtor realizes (and must recognize) income when
discharged of indebtedness. That is, when a debtor is relieved of indebtedness
without full payment of the amount owed, the debtor realizes taxable income in the
form of COD.

In Kirby Lumber, the taxpayer issued bonds for which it received par value. In the
same year, the taxpayer repurchased some of those bonds in the open market for
less than their par value issue price. The Supreme Court held the taxpayer must
recognize income in an amount (in that case $137,521) equal to the difference
between the issue price and the repurchase price of the bonds. In so holding, the
Supreme Court reasoned: “As a result of its [taxpayer’s] dealings, it made
available $137,521.30 [of] assets previously offset by the obligation of the bonds
now extinct.”
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KIRBY LUMBER IS CODIFIED
IRC § 61(a)(12) says:
“[G]ross income means all income from whatever source derived,
including …
(12) Income from discharge of indebtedness … .”
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HOW WILL YOU PAY THE TAX ON THE COD?
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WHAT TRIGGERS COD/TAXABLE GAIN?
The two most common COD events are:
 Forgiveness of debt – Kirby Lumber; IRC § 61(a)(12).
 Modification of debt/restructuring – Treas. Reg. § 1.1001-3.
Taxable gain under IRC § 1001(c) arises where there is:
 Foreclosures, deeds-in lieu and other transactions where an asset is
transferred to satisfy a debt. Rev. Rul. 90-16, 1990-1 CB 12.
 A “debt shift” in a partnership that gives rise to taxable gain as a result
of IRC § 752(b).
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BASIC TOOLS
The principal tool to exclude COD is in one section – IRC § 108:
 Per the legislative history of the 1980 Bankruptcy Tax Act, Section 108
was enacted to permit taxpayers who otherwise would have taxable
income resulting from forgiveness of debt to not be burdened with an
immediate tax liability. See S. Rpt. 96-1035, 1980-2 C.B. at 624 (1980).
But, there is no exclusion for taxable gain arising under § 1001(c).
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 Five principal parts of IRC § 108, which provides the exclusion from
income for COD, are where the:
Discharge occurs in bankruptcy (a Title 11 case); § 108(a)(1)(A).
Discharge occurs when the taxpayer is “insolvent”; § 108(a)(1)(B).
Debt is “qualified farm indebtedness”; § 108(a)(1)(C).
Debt discharged is “qualified real property business indebtedness”;
§108(a)(1)(D).
 Debt discharged is “qualified principal residence indebtedness” discharged
before January 1, 2013; § 108(a)(1)(E).




 There’s also a new five-year deferral – not exclusion – for COD to 2014
to 2018 for COD arising in 2009 or 2010; § 108(i).
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NOTHING IS FREE – SO WHAT’S THE COST?
The cost of exclusion of COD is the debtor must reduce tax attributes
by the amount of the COD excluded. § 108(b)(1).
 Unless all seven of the tax attributes listed in § 108(b) are exhausted,
the exclusion under § 108 is not a permanent exclusion but is, in effect,
a deferral of COD.
 If all seven tax attributes are exhausted, then the exclusion is
permanent.
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WHAT ARE THE ATTRIBUTES?
The seven attributes reduced under § 108(b)(2) are:
(A) Net operating losses (a/k/a “NOLs”).
(B) General business credits allowable under § 38.
(C) The minimum tax credit available under § 53(b).
(D) Capital loss carryovers.
(E) The tax basis of property of the taxpayer (note: this is “tax basis” and
not “depreciable basis” – more on this below).
(F) Any passive activity loss or credit carryovers under IRC § 469(b).
(G) Foreign tax credits allowable under § 27.
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AMOUNT OF REDUCTION
The reductions are made after determination of tax for the taxable year
in which the COD occurs. § 108(b)(4)(A).
 For attributes in dollar amounts, the attributes are reduced on a dollarfor-dollar basis of the excluded COD. § 108(b)(3)(A).
 For tax credits, the reduction is 33-1/3 cents for each dollar of excluded
COD. § 108(b)(3)(B).
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SPECIAL ELECTION FOR DEPRECIABLE PROPERTY
The attribute reduction under § 108(b)(2) for basis is for any “basis of
the property of the taxpayer.” § 108(b)(2)(E).
Under IRC § 108(b)(5), there is a special election to apply the attribute
reduction first against depreciable property. As a result of applying the
attribute election against depreciable property, this special election:
 Reduces future depreciation of the taxpayer – thereby highlighting the
deferral aspect of § 108.
 Only applies to depreciable property -- so land and other assets that
are not depreciable don’t qualify for the special election.
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COD FROM BANKRUPTCY
The exclusion from COD arising in bankruptcy only applies if:
 The taxpayer is under the jurisdiction of the bankruptcy court; and
 The COD arises as a result of a forgiveness of debt by the court or
pursuant to a plan approved by the bankruptcy court. § 108(d)(2).
So, the exclusion does not apply to COD that arises from a discharge
either before the bankruptcy case or after termination of the
bankruptcy.
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INSOLVENCY EXCEPTION
In light of the stigma associated with bankruptcy, the most commonly
used COD exclusion is the “insolvency” exception under §108(a)(1)(B).
 The term “insolvent” means the excess of liabilities over the fair market
value of a taxpayer’s assets. § 108(d)(3).
 The test of insolvency is determined immediately before the discharge
giving rise to the COD. § 108(d)(3).
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WHAT’S AN ASSET?
The definition of what is an “asset” for purposes of “insolvency” has
been the subject of much litigation. The principal question is whether
assets exempt from the claims of creditors under applicable state law
are included in “assets” for purposes of the insolvency determination.
 Ultimately, this is a question of policy because under the bankruptcy
exception assets exempt from creditors under state law are not treated
as an asset of the taxpayer.
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IS THERE A “FREEING OF ASSETS”?
After two decades of courts and taxpayers taking multiple positions on
what is an asset, the tax court in Carlson v. Commissioner, 116 T.C. 87
(2001) held:
 The legislative history showed that the Bankruptcy Tax Act of 1980
adopted a “freeing of assets theory”.
 Hence, assets exempt from the claims of creditors under applicable
state law are included when determining the fair market value of a
taxpayer’s assets for purposes of ascertaining whether the taxpayer is
“insolvent”.
 The Court’s rationale was if a taxpayer’s total assets – including exempt
assets – exceeds the debtor’s liabilities, the debtor has the ability to pay
an immediate tax on income from COD.
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WHAT’S A LIABILITY?
The term “liability” for purposes of insolvency was no easier to answer
but only took 17 years after the Bankruptcy Tax Act of 1980 to resolve.
 In Merkel v. Commissioner, 109 T.C. 463 (1997), the Tax Court held that
the term “liabilities” requires the taxpayer to prove that the taxpayer will
be called upon to pay the obligation in the amount claimed.
 Failure to prove the taxpayer would be called upon to pay the amount of
the obligation results in the obligation not being a “liability” for purposes
of the insolvency determination.
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WATCH THE SPECIAL RULES
In the case of individuals and C corporations, the tests for bankruptcy
and insolvency are straight forward. The determination is made at the
individual or C corporation level.
 For pass-through entities, the rules are not as easy.
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FOR PARTNERSHIPS
Where the entity in bankruptcy or potentially insolvent is a partnership,
then the exclusion of COD is applied at the partner, not the partnership,
level. § 108(d)(6).
 This means that if a partner is not in bankruptcy or insolvent, then the
partner will have taxable COD from the discharge of debt, despite
what’s occurring with the partnership.
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WHAT ABOUT S CORPS?
For S corporations, the provisions of § 108 are generally applied at the
S corp level.
 So, if the S corp is in bankruptcy or insolvent, then the bankruptcy or
insolvency determination is made at the S corp level, and not the
shareholder level. § 108(d)(7).
 This result was affirmed by Gitlitz v. Commissioner, 531 U.S. 206
(2001), which permitted basis for COD excluded by the S corp, thereby
allowing utilization of NOLs by the S corp shareholders. This decision
was reversed by Congress in 2002 (i.e., no basis for excluded income
under § 1367(a)). § 108(d)(7).
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OTHER SPECIAL RULES
There are a series of special rules in § 108(e) that can be traps for the
unwary. They include:
 Accrued interest and expenses – there is no income (i.e., no COD) to
the extent that the payment of a liability would give rise to a deduction.
§ 108(e)(2).
 This means if a cash basis taxpayer has not previously deducted the amount,
then the forgiveness of the expense does not give rise to COD.
 Related party acquisitions of debt – if a party related to an obligor
acquires the obligor’s debt, the acquisition is treated as if the obligor
reacquired the debt, thereby potentially creating COD. § 108(e)(4).
 The rule also includes an expanded definition of who counts as “related” that
is broader than general relationship rules under the Internal Revenue Code.
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OTHER SPECIAL RULES (cont.)
 Stock for debt – where a company exchanges stock for debt, the
exchange will typically give rise to COD. § 108(e)(6), (e)(7) and (e)(8).
 Partnership interest for debt – while for many years taxpayers took the
position that an exchange of a partnership interest for debt did not give
rise to COD, in 2004 Congress changed the Code to provide that a
partnership interest exchanged for recourse or nonrecourse debt gives
rise to COD. § 108(e)(8).
 Debt for debt exchanges – also give rise to COD to the extent of the
“issue price” of the new debt instrument (determined under the OID
rules) exceeds the amount of debt discharged. § 108(e)(10).
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WHAT ABOUT LAND CONTRACTS?
If there is a reduction in the purchase price between a seller and a
buyer where a note between the seller and the buyer is reduced, then
the reduction can be treated as a purchase price adjustment and not
as COD. § 108(e)(5).
 This special rule for purchase money debt reduction is especially
helpful when the buyer is not in bankruptcy and not insolvent.
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WHAT IS “RECOURSE” v. “NONRECOURSE” DEBT?
The definition of “recourse” and “nonrecourse” debt is one of the most
difficult issues yet to be resolved.
 In light of carve-outs in loan agreements (e.g., liability of borrower for
environmental issues), it becomes difficult to determine whether debt is
recourse or nonrecourse.
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§ 1001 GAIN RULES
The § 1001 rules regarding taxable gain highlight why it is important to
determine whether the underlying debt is recourse versus
nonrecourse.
 Recourse debt receives bifurcated treatment. Treas. Reg. § 1.10012(c), Example 8.
 Nonrecourse debt gives rise to taxable gain. § 7701(g).
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BIFURCATED TREATMENT FOR RECOURSE DEBT
Where a debt is recourse, then the amount of debt forgiveness that
exceeds the fair market value of property transferred is treated as
COD, and the fair market value of the property transferred becomes
the amount realized for determining gain under § 1001.
 Example 8, Treas. Reg. § 1.1001-2(c) describes how this calculation
works. It says:
In 1980, F transfers to a creditor an asset with a fair market value
of $6,000 and the creditor discharges $7,500 of indebtedness for
which F is personally liable. The amount realized on the
disposition of the asset is its fair market value ($6,000). In
addition, F has income from the discharge of indebtedness of
$1,500 ($7,500 minus $6,000).
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IMPACT ON FORECLOSURE OF PROPERTY
Although foreclosures typically result in an economic loss to the obligor
and owner of the property, it is common for the owner of the property to
realize taxable gain due to the low tax basis of the property.
 Although an involuntary act, foreclosure is treated as a sale or exchange
of the property by the taxpayer.
 As shown by Example 8, the gain or loss from the foreclosure is
determined in the same manner as an ordinary sale of property.
 For recourse debt, the amount above the fair market value of the property
is then treated as COD.
 Under the applicable case law, the amount bid in at a foreclosure
proceeding will, absent other evidence, be treated as the fair market
value of the property. See Carlson v. Commissioner, 116 T.C. 87 (2001).
 In a foreclosure transaction where there’s recourse debt, the transaction
is bifurcated and treated as part sale or exchange under § 1001 to the
extent of the “fair market value” of the property, and part discharge of
indebtedness resulting in COD.
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WHAT ABOUT IF THE DEBT IS NONRECOURSE?
The amount realized upon the foreclosure of property securing
nonrecourse debt is equal to the face amount of the debt discharged,
regardless of the property’s fair market value. Tufts v. Commissioner,
461 U.S. 300 (1983); § 7701(g).
 The importance is that there is no exclusion for taxable gain.
 So while the tax rate for taxable gain is currently lower than COD, there
are situations where taxpayers will have a better result with a recourse
debt as compared to nonrecourse debt.
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SPECIAL RULE FOR REAL ESTATE DEVELOPERS
After the 1990-1992 recession, Congress enacted a special rule for
real estate developers under § 108(c).
 The election is voluntary and is useful where the debt was incurred or
assumed to acquire, construct, reconstruct or substantially improve real
property or, in certain cases, resulted from refinancing indebtedness
incurred or assumed before January 1, 1993. § 108(c)(3).
 One catch – the election only applies with regard to reducing basis of
depreciable real property. It does not apply to land or other nondepreciable real property.
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FORGIVENESS OF DEBT FOR PRINCIPAL
RESIDENCES
In the 1990-1992 recession, certain taxpayers found that their house
was worth less than the debt against it. However, they couldn’t walk
away because they would have to pay tax on the COD. § 108(h).
 For tax years 2009, 2010, 2011 and 2012, taxpayers will be eligible to
exclude from income COD arising solely from debt discharged if the
debt is directly related to a decline in the value of the taxpayer’s
principal residence or the financial condition of the taxpayer.
§108(a)(1)(E), (h)(3).
 The exclusion is generally limited to mortgages on principal residences
of $2 million or less.
 The amount excluded reduces the basis of the taxpayer’s principal
residence.
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DEFERRAL AND RATABLE INCLUSION FROM
BUYING BACK DEBT
As part of the American Recovery and Reinvestment Tax Act of 2009, a
new deferral rule was enacted allowing taxpayers for 2009 and 2010 to
elect to include the COD from reacquiring debt for less than its face
value over a five-year period beginning in 2014 and ending in 2018.
§108(i).
 The election to have the five-year deferral to 2014 to 2018 contains
rules for how to allocate debt for C corporations and for pass-through
entities and authorizes the IRS to promulgate legislative regulations
regarding the deferral.
 There are rules for acceleration of the deferral in the event of the death
of a taxpayer, liquidation of the taxpayer (including in bankruptcy) or
cessation of business by the taxpayer.
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WHAT IF OBLIGOR IS A RELATIVE?
If the debtor is related to the lender as a family member, then the IRS
takes the position that cancellation of the debt is a gift. If the amount of
the gift exceeds the applicable gift threshold, then the gift can become
a taxable gift.
 If the gift is a taxable gift, and the debtor is insolvent, there is case law
authority that the amount of the gift is limited to the amount by which
the debtor becomes solvent.
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PARTNERSHIP DEBT SHIFT
In a partnership, partners are treated as having tax basis equal to the
amount of debt allocated to the partner. IRC § 752.
 When partnership debt is forgiven, partners can find the debt that
previously supported a “negative capital” account decreases or is
shifted to other partners. This is treated as a distribution of cash.
§752(b).
 If the § 752(b) distribution exceeds the partner’s tax basis in the
partnership interest, taxable gain results.
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BRINGING IT ALL TOGETHER
The above principals are highlighted by an example.
Problem:
ABC Partnership has been in business a number of years but recently
suffered because of the economic downturn. Its primary asset is a
manufacturing plant where it brews world-class beer. Despite the
interest of consumers in drowning their sorrows, the beer is not selling.
The manufacturing facility has a tax basis of $1 million, a fair market
value of $2 million and is subject to debt of $4 million.
ABC has four equal general partners, Big Jim “Potbelly” Walker, Donald
“Big Hair” Developer, Water Street Brewers, LLC, and Noseeum, Inc.
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 Big Jim “Potbelly” Walker is a successful and wealthy individual with a net
worth in excess of $50 million (i.e., he is “hopelessly solvent”).
 Donald “Big Hair” Developer is a real estate developer who finds himself
a bit over-extended as a result of the downturn in the real estate market.
He has personal liabilities for debts in excess of $50 million and his
projects are underwater by $15 million. Being a developer he is confident
things will turn around soon and he will be fine.
 Water Street Brewers, LLC is a family-limited liability company. Not much
is known about the profiles of the individual members but it is believed
that there are over 10 individual members all related to the founder of the
century-old brewery.
 Noseeum, Inc. is an S corporation that was carrying an active business of
a brewery, where the brewery business was contributed to ABC
Partnership. Noseeum now has its partnership interest in ABC
Partnership and about $200,000 of cash that it is ready to distribute to its
sole shareholder.
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ABC Partnership asks you if you can represent ABC Partnership in
negotiating a workout with its creditors and/or a possible bankruptcy.
ABC Partnership is interested in avoiding undesirable tax
consequences for its partners.
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