Napier & Company, LCC

The recent downturn in the economy along with the tightening of credit is affecting all businesses, including S Corporations. A financially distressed S Corporation may have to work with it’s creditors to restructure debt in order to ease it’s financial difficulties. These transactions may include:

• Subordinating shareholder debt to a third party
• Issuing stock to creditors
• Soliciting additional capital contributions

Easing financial difficulties may involve debt forgiveness. The general rule of tax law is if a taxpayer is relieved of or forgiven indebtedness, it becomes ordinary income. IRC Code Section 108 has exceptions to this rule such as:

• Taxpayer is bankrupt under Chapter 11
• Taxpayer is insolvent
• Taxpayer has qualified real property business debt (applies only to reduce the basis of depreciable real property)

If the taxpayer meets one of the exceptions under Section 108, the debt forgiveness amount is excluded from income and certain tax attributes must be reduced for the amount of debt forgiveness income. These attributes are:

• Net Operating Losses
• General business credits
• Minimum tax credits
• Capital losses
• Reduce basis in depreciable assets

Another tax provision to avoid recognizing any taxable gain in debt restructuring is an E reorganization under Section 368(a)(1)(E). This allows entities to restructure the liabilities and equity section of the balance sheet without recognizing any taxable gain. Some of the ways to reorganize are to convert debt to equity or move shareholder debt from senior to junior status. The distressed S Corporation needs to be careful of the significant modification of debt rules which may trigger taxable income. Any significant modification of the loan terms will be material unless the IRS has specifically exempted the modification as immaterial. Changes in the debt instrument are not considered modifications.

One other area the S Corporation needs to be careful of is issuing a second class of stock or stock issues to help restructure debt because a second class of stock would terminate the S election. To maintain one class of stock, the S Corporation must not enter into an arrangement where stock warrants or stock rights are treated as a second class of stock.

Theses are some of the points with regards to excluding debt forgiveness income from taxable income. Please feel free to contact us to discuss your situation.