Restructuring Businesses in the 1990s: Both Tax and Accounting Considerations Prevail When Refinancing Troubled Companies
Both tax and accounting considerations prevail when refinancing troubled companies. As the havoc wrought by the leverage binge of the 1980s becomes more evident, many companies are force to restructure to avoid bankruptcy. Declining growth and overleveraging have caused companies to attempt major capital structure adjustments. Investors, seeking to profit from such situations, have adopted a variety of strategies for securities of distressed companies. New terms such as reverse LBO, prepackaged bankruptcy and fulcrum security have entered the business lexicon. (For definitions of some of these new terms, see the glossary on page 29). This article reviews some key federal income tax and accounting concepts related to the burgeoning area of restructuring and refinancing troubled companies. TAX ATTRIBUTES Troubled companies often experience losses for a number of years. For such companies, tax attributes such as net operating loss (NOL) carryforwards may be one of the major elements of value. Careful planning is required to minimize limitations on the use of NOLs in the going-forward entity. Before considering use of NOLs, it's necessary to carefully evaluate the quality of the losses. Restructuring is a wasted exercise if NOLs are based on highly aggressive tax position unlikely to withstand Internal Revenue Service scrutiny. Such positions might include writeoffs of purchased intangible assets, covenants not to compete and acquisition and financing fees. Potential consolidated return liabilities for unpaid taxes of former affiliated companies or potential claims against affiliates for the uncompensated use of prior losses should also be evaluated. From a restructuring viewpoint, issuing stock in exchange for debt or fresh equity can severely limit use of existing NOLs. A limitation arises if, within three years while losses exist, there is a greater-than 50% increase (measured by value) in the direct or indirect ownership of a company. This simple formula may lead to some surprising results. In the scenario illustrated in the exhibit on page 31, an ownership change has occurred; there has been a greater-than-50% increase in ownership, even though no single shareholder has gained control. Planning opportunities also can be found. Because the rules focus only on value, it is possible to provide voting control or common equity to a new investor without triggering a change, for example, by having existing shareholders retain sufficient preferred stock. Options to acquire stock and other executory contracts are deemed exercised, regardless of contingencies, but only when exercise would trigger an ownership change. If an ownership change occurs, the annual limit on the use of NOLs thereafter is equal to the fair market value of all classes of equity immediately before the transaction multiplied by a federal long-term tax-exempt rate, currently about 6 1/2%. Any unused annual limit is added to the next year's limit. Depending on the overall fair value of the company's assets relative to their tax basis at the time ownership changes, further adjustments are possible. For example, accrued expenses and "built-in" losses on assets recognized after the ownership change can be subject to the limitation as well. On the other hand, accrued income and built-in gains recognized after ownership changes may be sheltered by perchange NOLs without limitation. It is critical both in measuring overall equity value (at least for private companies) as well as adjustments for accrued or built-in items, to have an accurate tax valuation performed. BANKRUPTCY AND INSOLVENCY Generally, there are no immediate tax costs or effects from filing for protection under chapter 11 of the Bankruptcy Code. However, a company reorganizing under the code receives more favorable tax treatment to assist in its rehabilitation. Indeed, tax factors may cause a company to consider a bankruptcy filing, especially if the settlement can be preapproved. …