Category: Bankruptcy, Insolvency,
and Debt Discharge Copyright 1998, The Tax Resource Group. All
rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Background A lender or group of lenders made a loan in the amount of $17 million to three individuals--Messrs. X, Y, and Z--for purchase of the stock of XYZ, Inc. (an S corporation). At some point, the lenders insisted that XYZ, Inc. (XYZ) become a named borrower on the note. XYZ at that point became a named borrower and became jointly and severally liable on the note with the individuals even though XYZ never got any of the loan proceeds. XYZ executed a note payable to the shareholders, Messrs. X, Y, and Z. On XYZ's books, there was a debit to goodwill and an offsetting credit to notes payable to shareholders. The note between XYZ and the shareholders was interest bearing. Pursuant to Sections 267(a) and 267(e)(1)(B)(ii) XYZ was barred from taking a deduction for accrued but unpaid interest owed to its shareholders. As cash basis taxpayers, the shareholders did not deduct the unpaid interest on the note due to the bank. In 1993 or 1994, the bank debt was restructured and the accrued and unpaid interest expense was forgiven. The total debt (principal and interest) was reduced by about $6 million related almost entirely to unpaid interest. As a result of the restructuring with the lender, the debt between XYZ and the shareholders was also restructured. The reduction of the amount owed by XYZ to the shareholders was reduced by $6 million and of that amount, the great majority consisted of unpaid interest. Discussion The restructuring of indebtedness, both as between XYZ and its shareholders and between the shareholders and the lender, should not give rise to cancellation of debt income to the extent the amounts forgiven in the transaction represented accrued but unpaid interest. Section 108(e)(2) provides that no income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction. XYZ was required by Sections 267(a) and 267(e)(1)(B)(ii) to defer deduction of interest with respect to its loan from shareholders until such time as the interest was actually paid. The interest in question was never paid and thus no deduction was ever taken by XYZ. Had the interest been paid, there is no question that a deduction would have resulted. As such, it seems that Section 108(e)(2) clearly shields XYZ from COD income to the extent the discharged debt represents accrued but unpaid interest. Note the statutory language "would have given rise to a deduction". I presume it is possible that XYZ might have been required, if the interest had ever been paid, to capitalize the interest as part of construction in progress or some other such capitalization requirement. The outcome in this situation is not specified, although it is widely assumed a deduction is not literally required nor is it necessary to have a current deduction. For example, in PLR 8617003, the IRS ruled that Section 108(e)(2) applied to forgiven foreign taxes where the taxpayer would have been allowed a foreign tax credit had the taxes been paid. The ruling said the IRS takes the position that but for the taxpayer's election to take a credit for foreign taxes, a deduction would have been allowed. In this case, an indirect deduction would ultimately be allowed for capitalized interest amounts either through depreciation or amortization deductions. Incidentally, the statute does not say "payment of the liability would have given rise to an immediate or current deduction". Although this matter seems never to have been tested in the courts, a deduction at some point would seem to me to be good enough to satisfy the literal language of the statute. With respect to the shareholders Mssrs. X, Y, and Z, no deduction was taken for interest expense because these individuals are cash basis taxpayers. Again, Section 108(e)(2) should apply to the shareholders to shield them from COD income to the extent the amount of debt forgiven represented accrued but unpaid interest. Here too I suppose the issue of immediate deductibility comes into play as well. If the shareholders had paid the interest, would it have been immediately deductible? If so, fine, but if the interest would have been suspended, let's say because of the investment interest rules or the passive activity rules, then we again have the question of whether the literal requirement of Section 108(e)(2) has been met. I think, although this is not certain, that the IRS is lenient with this interpretation--judging by PLR 8617003. I hope this issue is not raised, but if it is, I wonder if it would be strategically wise to ask for a Technical Advice Memorandum? Section 108(e)(2) renders moot the argument
with the agent over application of the tax benefit rule. To the extent there is any debt forgiven in excess of accrued interest expense, such amounts should be excludible by XYZ based on the insolvency exception. On the other hand, there is nothing to shield the individuals, assuming they are solvent, from COD income. Obviously, allocation of the potential COD amount as between the various parties is critical. Apparently you and the agent don't agree on this point, but I do not know exactly what you have suggested to her as an allocation. Unfortunately, there is really nothing that spells this out. As a practical matter, it is normally fairly clear who has borrowed money and in what amount. Accordingly, it is normally fairly easy to determine who should get COD income. It simply has not been necessary, it seems, for a court (or the IRS through a published or even a private ruling) to answer this question. The obvious answer is to allocate the COD as the loan proceeds were allocated. I cannot imagine being able to justify any other conclusion. Clearly, the answer is not to allocate--by virtue of joint and several liability--the entire COD amount to each taxpayer. Regarding strategy for your upcoming meeting, I would simply go prepared to demonstrate the following: 1. the accrued but unpaid interest component of the COD amounts at issue; 2. the fact that the taxpayers did not take deductions for such amounts; and 3. the text of Section 108(e)(2). I would then simply assert that Section 108(e)(2) is dispositive of the matter and see what the agent does. In addition, I wouldjust to be preparedgive some thought to what exactly would have happened had the interest amounts in question been paid. Would the taxpayers have been required to capitalize or suspend deductions for any reason? Please contact me if you have questions or wish to discuss this further. |
