Exploring Tax Impact on Debt Modifications for Business

Understanding Tax Implications of Debt Modifications

According to the IRS, most cancellations of debt are taxable. When taxpayers are relieved from the legal obligation to repay a loan, they must recognize this cancellation of debt (COD) as income and pay taxes on it unless specifically excluded under the tax laws. COD income can arise when loans are forgiven, settled for less than the amount due, or as a result of debt restructuring.

Taxable debt restructurings can take many forms. Modifying key terms, such as changing interest rates or payback periods, making a stock-for-debt exchange, or selling publicly traded debt to a related party, are simple tweaks that can trigger income tax consequences for the borrower. Understanding COD income recognition rules is especially important in today’s environment, where high interest rates, increased trade tariffs, and economic uncertainty put significant financial pressure on businesses. Many portfolio companies may be struggling to service their debt, so debt restructurings could become more frequent. Private equity and venture capital firms (PE/VC) should be mindful that debt modification tax issues may be common in the months ahead as economic uncertainty continues.

Why Debt Modification Tax Issues Are Increasing

In today’s higher interest rate environment, more portfolio companies are under financial pressure, leading to an increase in borrower-lender negotiations. Many of these companies, especially those backed by private equity or venture capital, face unique constraints due to affiliation rules that can limit access to traditional financing options.

As a result, these borrowers often must restructure their debt independently. For companies facing liquidity challenges, simply requesting relief from late payment penalties may not be enough. Instead, full renegotiation of loan terms is becoming more common. In some instances, COD income can be difficult to avoid. In those situations, borrowers should regard COD income as an additional cost of the new loan when evaluating the economics of a new loan structure.

What is COD Income?

Although most debt forgiveness is included in gross taxable income, the IRS Code provides a few exceptions. If an exception applies, then the COD amount may not be taxable. For example, when: i) debt is discharged in a bankruptcy proceeding; or ii) debt of an insolvent debtor is cancelled — to the extent that the debtor is not made solvent by such action — while taxpayers have COD income, these amounts can be excluded from gross income.
While this would seem to make the COD amount nontaxable, the Code requires a taxpayer to reduce certain listed tax attributes, such as net operating losses, general business or minimum tax credits, capital loss carryovers or basis of certain property. As a consequence, the debtor may only get a deferral of the income tax consequences. Furthermore, for tax partnerships, many of the exclusions are tested at the partner and not the entity level, making the tax effects difficult to predict any potentially different for the partners.

While debt forgiveness may be an option, portfolio companies are much more likely to recognize COD income from debt modifications.

Debt Modifications

When portfolio companies modify or restructure their existing debt, they may need to recognize taxable COD income. In today’s environment, borrowers may seek temporary relief from foreclosures or collections due to cash flow challenges. This modification should not be considered COD income if the forbearance is granted for a period not longer than two years. However, this allowance only goes so far.

When creditors implicitly or explicitly defer interest and principal payments, the IRS may classify the change as a “significant” debt modification and treat it instead as a taxable exchange of a debt instrument. The IRS will determine the materiality of the change by looking at all the facts and circumstances. Still, the only way for taxpayers to guarantee a tax-free modification is if they qualify for the IRS’s safe harbor.

The safe harbor states that the taxpayer must make up all deferred payments within a period that begins on the original due date for the first scheduled payment that is deferred, and ends on the earlier of:

• Five years later, or
• 50% of the loan’s original term.

Payment extensions made beyond that timeline may still qualify for tax-free treatment, but they must be analyzed further to determine if they represent a significant modification of the debt. Generally, the IRS will view a material deferral of payments as a significant modification of the debt instrument. The regulations provide for tests under which a debt modification needs to be analyzed. The testing criteria include changes in:

• Yield,
• Timing of payments,
• Obligor or security,
• Nature of the debt instrument, or
• Accounting of financial covenants.

There is also a general test that examines facts and circumstances to determine if the legal rights or obligations have been modified to an economically significant extent.

Where a significant modification of debt has occurred, a new (modified) debt instrument is deemed to have been issued in exchange for the old (unmodified) debt instrument. This is called a debt-for-debt exchange.  The debtor recognizes COD income when the adjusted issue price of the old debt instrument exceeds the issue price of the newly deemed debt instrument.

Publicly and Not Publicly Traded Debt

Determining if a significant debt modification occurred will differ if the debt instrument is privately held or publicly traded. Unfortunately, it is not always clear when debt is deemed to be publicly traded.

In 2012, the IRS released regulations that stated property (including debt instruments) is publicly traded if, at any time during the 31-day period ending 15 days after the loan’s issue date, the property has:

• A sales price from an actual trade, or
• One or more firm or indicative quotes from a broker.

The one exception to this rule is for small debt issuances. Debts with outstanding principal balances of $100 million or less at the time of the deemed debt-for-debt transaction will not be considered publicly traded and will be taxed as if the exchange were of two private debt instruments.
If the debt is determined to be publicly traded, then under the debt-for-debt exchange rule (described above), the old debt instrument is treated as being paid off by an amount equal to the value of the deemed new debt. If the value of the traded debt has decreased, there is a greater likelihood of a COD event.

The tax consequences of modifying publicly traded debt are twofold. First, taxpayers may need to recognize COD income in more circumstances than those holding private debt. Second, the new debt instrument may carry an original issue discount (OID).

Businesses that modify publicly traded debt instruments are more likely to recognize COD income than those with private debts because the IRS defines significant modification differently for each. When a business retires publicly traded debt and purchases new debt, the IRS will deem there to be a significant modification of the debt instrument if the debt is trading below its market value. The market values of privately held debts are not under the same scrutiny.

Similarly, when businesses purchase publicly traded debt at a discount from a related party, the debtor may also need to recognize COD income. This is a common scenario for PE/VC firms. If a PE/VC owner purchases a portfolio company’s publicly traded debt for a discount, the portfolio company will likely need to recognize COD income.

When publicly traded debt instruments have been significantly modified, the borrower will recognize COD income at the time of the exchange and recognize OID over the life of the new debt. However, OID interest may not be fully deductible due to the business interest expense limitations introduced by the Tax Cuts and Jobs Act (TCJA). These limitations continue to pose challenges, especially for highly leveraged companies. Let’s look at a significant debt modification example where OID is present:

Company holds $100,000 of publicly traded debt, but after the market dips, its debt is only valued at $90,000. Because the coronavirus upset their business operations, Company can no longer service this debt. To address their liquidity concerns, their lender agrees to a deferral of interest payments by two years. Although the issue price of the new debt is $100,000, its value reflects that of the old debt ($90,000), which means that the Company recognizes COD of $10,000 and the new debt is issued with OID of $10,000.

Cash Flow Considerations Related to the Tax Impact of COD Tax Treatment

COD income is considered ordinary income for tax purposes, which means the owners of pass-through borrowers will owe taxes at their highest marginal tax rate, not at a more favorable capital gains rate. In addition, the amount that was forgiven is taxable even if the business replaces that loan with new debt. Because COD income is taxable in the year the debt is discharged, portfolio companies and their owners may find it difficult to pay the COD tax liability while staying current on new debt payments.

Unused net operating losses (NOLs) can help portfolio companies absorb extra tax liabilities. While federal rules now limit NOL deductions to 80% of taxable income with indefinite carryforward, several states, including Connecticut and Rhode Island, are expanding carryforward periods. Still, losing tax attributes to renegotiate debt can be a difficult pill to swallow.

Final Thoughts on Debt Modifications for Business

Cancellation of debt can be a particularly tricky subject for portfolio companies entering into debt negotiations with their lenders. Borrowers would be wise to consult an expert when negotiations are in process. If they can structure debt modifications with taxes in mind, portfolio companies can mitigate COD income exposure and properly manage the payment of additional taxes when COD income cannot be avoided.

If one of your portfolio companies needs to modify or renegotiate its debt or you have any other concerns related to private equity or venture capital business issues, please contact us.