Category: Corporations; Bankruptcy, Insolvency &
Debt Discharge Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer (TP) is a C corporation engaged in the business of steel fabrication. TP desires to buy the business of a competitor. The competitor's operation consists of an operating company--a C corporation (C Corp), and a leasing company--an S corporation (S Corp). S Corp owns the land and building on which C Corp's business in conducted. S Corp leases the land and building to C Corp. C Corp has an unused net operating loss of approximately $500,000. C Corp owes approximately $125,000 to S Corp related to purchase of equipment. The debt is secured by the equipment. C Corp owes approximately $125,000 to its individual shareholder. 100% of the stock of both C Corp and S Corp is owned by a single individual. TP plans to buy 100% of the stock of S Corp. Thereafter, C corp will arrange to file for bankruptcy and C Corp will issue common voting stock to S Corp in full satisfaction of its debt to S Corp. After the transaction, S Corp will own the majority of C Corp's stock. The debt owed by C Corp to its individual shareholder will remain in place. C Corp is insolvent both before and after the proposed transaction. It is assumed that the stock issued to S Corp in satisfaction of its debt will be worth far less than the face amount of the debt. It is assumed that this transaction will be consummated in calendar 1994. Otherwise, the conclusions set forth below are not valid. Issues 1. Does IRC Section 108 operate to exclude cancellation of indebtedness (COD) income to C Corp with respect to the transaction set forth above? If so, what is the effect, if any, on C Corp's NOL and other tax attributes? 2. Does §382 operate to limit the amount of C Corp's NOL's and other tax attributes available to offset income and tax arising after the transaction? 3. Does S Corp have a bad debt loss as a result of this transaction? Answers 1. §108 does not provide relief from COD income in this case, but it appears that a judicially created stock for debt exception applies and provides relief from both COD income and the need to reduce tax attributes. It is important to understand that the taxpayer's ability to rely on the judicially created stock for debt exception is not free from risk. 2. §382 significantly limits the ability to utilize NOL's and other tax attributes. 3. The transaction does not give rise to a bad debt deduction for S Corp. Instead, it appears the transaction produces a capital loss instead. Discussion: Issue One 108(e)(10) INDEBTEDNESS SATISFIED BY CORPORATION'S STOCK.-- 108(e)(10)(A) IN GENERAL.--For purposes of determining income of a debtor from discharge of indebtedness, if a debtor corporation transfers stock to a creditor in satisfaction of its indebtedness, such corporation shall be treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the stock. On its face, it would appear that satisfaction of debt with an amount of money equal to the fair market value of the stock issued would present a problem in this transaction. In essence, C Corp would be treated as fully satisfying its debt with an amount of money far below the face amount of its debt. Normally, this would give rise to COD income and attribute reduction. The provision goes on to provide as follows. 108(e)(10)(B) EXCEPTION FOR CERTAIN STOCK IN TITLE 11 CASES AND INSOLVENT DEBTORS.-- 108(e)(10)(B)(i) IN GENERAL.--Subparagraph (A) shall not apply to any transfer of stock of the debtor (other than disqualified stock)-- 108(e)(10)(B)(i)(I) by a debtor in a title 11 case, or 108(e)(10)(B)(i)(II) by any other debtor but only to the extent such debtor is insolvent.On its face, this latter passage tells us that the statutory stock for debt exception is not available to insolvent and bankrupt taxpayers. This implies that such taxpayers are simply not protected as regards stock issued in satisfaction of outstanding indebtedness. In reality, the language of the statute is really an extremely convoluted way of allowing bankrupt and insolvent taxpayers to use the judicially created stock for debt exception through the end of 1994. Since the statute provides that §108(e)(10)(A) does not apply to bankrupt or insolvent taxpayers, the effect is to shield such taxpayers from the harsh rule of §108(e)(10)(A) and tacitly allow them to find refuge in other available COD avoidance mechanisms--namely the judicially created stock for debt exception. After 1994, the language of §108(e)(10)(A) will be incorporated into the Code at §108(e)(8) and the §108(e)(10)(B) exception will go away thereby statutorily closing the door on the judicially created stock for debt exception. There is a body of case law representing the judicial stock for debt exception. The principal cases are Capento Securities Corp. v. Comm'r, 47 BTA 691 (1942), aff'd, 140 F 2d 382 (1st Cir. 1944) and Comm'r v. Motor Mart Trust, 46-1 USTC ¶9301 (1st Cir 1946). In Capento, the court held that issuance of preferred stock in exchange for outstanding indebtedness did not create COD income because the transaction amounted to a mere reshuffling of the corporate balance sheet by substituting a corporate stock "liability" for the existing debt. In Motor Mart, the court held that it is economic nonsense to contend that there is an increase in corporate wealth as a result of the substitution of stock for the existing indebtedness of an insolvent taxpayer. The taxpayer's facts as described above seem to be sufficiently close to those of Motor Mart to provide a comfort level that the taxpayer can rely on the Motor Mart result; however, it is possible that the IRS could argue that the taxpayer's facts are in some way different from those of Motor Mart in order to distinguish the taxpayer from the case and its conclusion. Of course, the ultimate risk of such an attack is based not only on the rather sparse facts upon which this work is based but rather upon all the facts that the IRS could develop if this issue were raised on examination. In other words, the risk is based not so much on the facts I can see but rather upon the facts I cannot see. Discussion: Issue Two 1. The loss corporation (C Corp) must be under the jurisdiction of a bankruptcy court immediately preceding the ownership change. 2. The shareholders and creditors immediately before the ownership change must end up owning at least 50% of the voting power and value of the loss corporation's stock after the ownership change. Stock transferred to a creditor only counts for this purpose if the debt was held by the creditor for at least 18 months before the bankruptcy petition.If the requirements are met, the ordinary §382 limitations do not apply. However, there is still a heavy price to pay. 1. Available NOL's and other tax attributes must be reduced by the amount of interest expense paid or accrued with respect to debt converted into stock in the bankruptcy. 2. Available NOL's and other tax attributes must be further reduced by one-half the amount COD income that would have been recognized if §108(e)(10)(B) did not exist. In other words, attributes must be reduced by one-half of the COD income that would have been recognized had the judicially created stock for debt exception not been available. 3. Finally, if a second ownership change occurs within two years after the §382(l)(5) change, the §382 limit is set to zero. It should be noted that the taxpayer may elect out of the provisions of §382(l)(5). Discussion: Issue Three Collateral Issue Not Addressed: |
