ALI-ABA Course of Study Consolidated Tax Return Regulations. Cosponsored by the ABA Section of Taxation October 1-2, 2009 Washington, D.C.

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1 2061 ALI-ABA Course of Study Consolidated Tax Return Regulations Cosponsored by the ABA Section of Taxation October 1-2, 2009 Washington, D.C. Restructuring Troubled Companies By Lisa M. Zarlenga Steptoe & Johnson LLP Washington, D.C. Copyright 2009 Lisa M. Zarlenga. All Rights Reserved.

2 2062 TABLE OF CONTENTS Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein. Table of Contents Page I. OPTIONS FOR RESTRUCTURING DEBT...1 II. III. A. Cancellation or Reduction of Debt...2 B. Satisfaction of Debt for Less than Full Amount...2 C. Debt for Debt Exchange...4 D. Modification of Debt...5 E. Equity for Debt Exchange...6 F. Capital Contribution of Debt...8 MODIFICATION OF DEBT...10 A. In General...10 B. Modification Defined...10 C. Timing of Modification...12 D. Significant Modification Defined...12 E. Election to Treat Debt Substitution as an Exchange...17 SECTION 108 EXCLUSIONS FOR COD INCOME...17 A. General Rule...17 B. Section 108 Exclusions Bankruptcy Exclusion Insolvency Exclusion Qualified Farm Indebtedness Exclusion Qualified Real Property Indebtedness Exclusion Qualified Principal Residence Indebtedness Exclusion Student Loans Purchase Price Reductions Contested Liabilities Deductible Liabilities...22

3 2063 IV. C. Deferral of COD Section 108(i)...22 D. Reduction of Attributes...23 DEDUCTIONS FOR WORTHLESS SECURITIES OR BAD DEBTS...29 A. Worthless Securities Deduction Section 165(g) In General Character of Loss Security Establishing Worthlessness...30 B. Bad Debt Deduction Section In General Business vs. Nonbusiness Bad Debts Complete vs. Partial Worthlessness Establishing Worthlessness Recovery of Bad Debt...33 V. TAX-FREE RESTRUCTURINGS INVOLVING INSOLVENT COMPANIES...34 A. Tax Consequences of Tax-Free Reorganization Tax Consequences to the Debtor Tax Consequences to the Creditor...39 B. Recapitalizations E Reorganizations...41 C. Insolvency Reorganizations G Reorganizations Background Title 11 or Similar Case Distribution Qualifying Under Section 354, 355, or Substantially All Requirement Continuity of Interest Requirement Continuity of Business Enterprise Requirement Proposed Net Value Requirement Triangular G Reorganizations...67 D. Sideways Asset Reorganizations A, C, D, and Forward Triangular Reorganizations A, C, D and Forward Triangular Reorganizations in General Substantially All Requirement Exchange Requirement...75

4 COI and COBE Requirements Solely for Voting Stock Requirement Liquidation Requirement Control Requirement Proposed Net Value Requirement Examples...80 E. Stock Reorganizations B and Reverse Triangular Reorganizations B Reorganizations Reverse Triangular Reorganizations...87 F. Upstream Asset Transfers Liquidations and Upstream Reorganizations Liquidations of Insolvent Subsidiaries Upstream Reorganizations Involving Insolvent Subsidiaries Consequences of Failure to Qualify under Section 332 or Making the Subsidiary Solvent Before the Liquidation or Upstream Reorganization Examples Illustrating Liquidations and Upstream Reorganizations...99 G. Section 351 Transactions In General Transfer of Underwater Assets Receipt of Stock in Exchange Transfers By Creditors VI. TAXABLE STOCK ACQUISITIONS OF INSOLVENT SUBSIDIARIES VII. SPECIAL CONSIDERATIONS WHERE THE DEBTOR IS A DISREGARDED ENTITY A. Whose Debt Is It the Disregarded Entity s or the Owner s? B. Effect of Check-the-Box Elections C. COD Income D. Indebtedness to Owner of Disregarded Entity E. Guarantee of Debt of Disregarded Entity...113

5 2065 RESTRUCTURING TROUBLED COMPANIES In general, the mere existence of a debt results in no federal income tax consequences to either the debtor or creditor. This is because the debtor s receipt of property or services that give rise to the debt are offset by the debtor s obligation to satisfy the debt (i.e., the debt results in no economic benefit to the debtor and no economic detriment to the creditor). However, if the amount of the debt is subsequently cancelled, reduced, or otherwise modified, or the debt is exchanged for new debt or stock of the debtor, the debtor and creditor may realize an economic benefit and/or detriment, respectively. Under these circumstances, federal income tax consequences may result for both the debtor and creditor. The tax consequences are not clear when an insolvent debtor corporation undertakes to restructure itself, whether it be through a reorganization, liquidation, or section exchange, because the corporation has no net equity value. On March 10, 2005, the Internal Revenue Service (the Service ) issued proposed regulations to provide guidance on this issue. As discussed further herein, the proposed regulations provide rules in two main areas: (i) rules requiring the exchange (or, in the case of a section 332 liquidation, a distribution) of net value for the nonrecognition rules of subchapter C to apply (referred to herein as the proposed no net value regulations ); and (ii) rules for determining when and to what extent creditors of a corporation will be treated as proprietors for purposes of the continuity of interest requirement for reorganizations (referred to herein as the creditor continuity regulations ). 2 This outline addresses the tax consequences of debt restructurings generally with a particular focus on transactions to restructure the debtor corporation. 3 The outline discusses the historic guidance (or lack thereof) governing restructurings of insolvent corporations as well as the rules set forth in the proposed no net value regulations and the creditor continuity regulations. I. OPTIONS FOR RESTRUCTURING DEBT A debtor that finds itself unable to service its debt may seek any one of a number of options to restructure that debt, some of which are taxable and some of which may qualify for tax-free treatment. These options and their tax consequences are summarized in this section and described in greater detail below. 1 Unless stated otherwise or clear from the context, references to section are to the Internal Revenue Code of 1986, as amended, and references to Reg. are to the Treasury regulations thereunder. 2 These proposed regulations are discussed further in an article published in The Tax Executive. See Mark J. Silverman, Lisa M. Zarlenga, and Gregory N. Kidder, Assessing the Value of the Proposed No Net Value Regulations, 67 TAX EXECUTIVE 270 (May June 2005). 3 The analysis of these issues in a consolidated return context is beyond the scope of this outline. Accordingly, the discussion in this outline assumes that the debtor and creditor are not members of a consolidated group.

6 A. Cancellation or Reduction of Debt 1. A creditor may agree to a full or partial cancellation of the debt ( COD ). 2. Section 61(a)(12) provides that gross income includes income from the discharge of indebtedness. See also Reg (a); United States v. Kirby Lumber Co., 284 U.S. 1 (1931). In general, COD will result in income to the debtor equal to the amount of debt canceled. However, if the debtor is insolvent or in bankruptcy, it may exclude the COD income under section The creditor may be entitled to a corresponding deduction under either section 165 (for worthless securities) or section 166 (for bad debts). B. Satisfaction of Debt for Less than Full Amount 1. A creditor may agree to accept less than the full amount of the debt in complete satisfaction of the debt. 2. If the debtor satisfies its debt for cash, it will realize COD income equal to the difference between the adjusted issue price of the debt 4 and the amount of cash given in satisfaction of the debt. Section 61(a)(12). 3. Similarly, if a person related to the debtor acquires the outstanding indebtedness for less than its full amount, the debtor is treated as having satisfied the debt (recognizing any COD income) and reissuing it to the related person. Section 108(e)(4); Reg (a), (g)(1). a. A person is related to the debtor if they bear a relationship specified in section 267(b) or 707(b)(1) or are under common control with the debtor as specified in section 414. b. The amount of COD income realized by the debtor is equal to the difference between the adjusted issue price of the debt and the related party s purchase price. Reg (f)(1). 4. If the debtor satisfies its debt for other property, the tax consequences differ depending on whether the debt is recourse or nonrecourse. 4 The issue price of a debt that is publicly traded is its trading price. Section 1273(b)(3). If the debt is not publicly traded, the issue price is equal to its stated principal amount if the instrument provides for interest that equals or exceeds the applicable federal rate ( AFR ). Section 1274(a)(1), (c)(2). If the non-publicly traded debt does not provide for adequate stated interest, then the issue price is determined by discounting all payments due under the terms of the debt (including interest and principal) at the AFR. Section 1274(a)(2), (b).