Hidden Tax Consequences of Restructuring Debt
Restructuring debt usually is seen as a means of relieving the debtor's burden. But the process also is plagued with unforeseen income tax problems. Adverse tax consequences can occur when taxpayers in financial distress dispose of business assets or when debt is either written down or completely forgiven. This month, Daryl V. Burckel, CPA, DBA, professor of accounting, McNeese State University, Lake Charles, Louisiana, and Zoel W. Daughtrey, CPA, PhD, Tenneco Professor of Accounting, Mississippi State University, Starkville, explain how disposition of assets can create unanticipated tax liability in the form of capital gains and discharge of indebtedness income. Since debtors usually don't have the resources to pay the resulting tax, it's important practitioners make clients aware of the tax implications of transferring assets directly to creditors. Proper planning can minimize the tax burden. When a borrower's obligation to repay a debt is reduced, there may be income tax consequences that depend on the reason for the reduction and the borrower's financial status at the time. In many transactions, debt is reduced because the borrower repaid all or part of it by transferring something of value, such as property, to the lender. If debt is reduced in this way, the borrower is treated as if the lender bought the property for cash and the borrower used the cash to repay the debt. Although repaying the debt yields no income tax consequences, there may be some tax consequences from transferring the property. If the lender receives no consideration (cash, property, etc.) for all or part of the debt reduction, it is either a gift or a discharge of indebtedness. If a gift, the amount of the reduction is not income to the borrower. If a discharge of indebtedness, the reduction is income, unless * Payment of the debt would have allowed the borrower to claim a deduction. * The borrower was in bankruptcy at the time of the reduction. * The borrower was insolvent at the time of the reduction. * The discharge was qualified farm indebtedness. * The debt was between the original buyer and seller under a seller-financed transaction. INSOLVENCY EXCEPTION Under the insolvency exception in Internal Revenue Code section 108, discharge of indebtedness income can be excluded from taxable income by an insolvent taxpayer except to the extent he or she becomes solvent as a result of the discharge. Before 1980, several court decisions clearly applied the exception to amounts that exhibit 1, at right, would characterize as gain on sale ineligible for the exclusion. The most important case was Dallas Transfer and Terminal Warehouse Co. v. Commissioner (70 F.2d 95), in which the taxpayer transferred property to a creditor in satisfaction of a recourse debt. The satisfied debt exceeded the property's value, which in turn exceeded the property's adjusted tax basis. The Fifth Circuit Court of Appeals held no income was to be recognized because the taxpayer was not made solvent by the transaction. This case was cited by Congress when the insolvency exception was certfied in 1980. The IRS acquiesced in a subsequent Tax Court decision that adopted Dallas Transfer's liberal approach. In 1987, however, the IRS changed its position, narrowing its view of discharge income and the insolvency exception. Now the courts must determine whether the insolvency exception in section 108 is the one described in Dallas Transfer or the IRS's more limited concept. TRANSFERRING ASSETS Income tax liability does not result from the transfer of a debtor's assets to a bankruptcy estate. Upon such a transfer, the bankruptcy estate, as property owner, is treated as the debtor would have been if there was no bankruptcy. However, such treatment does not apply if assets are transferred directly to creditors. Generally, transfers to creditors result in gain or loss and in recapture income. …