COMPANIES THAT HAVE BORROWED MONEY should be careful when changing their tax classifications. It could trigger taxes on the debt instrument.

The US treats any “significant modification” of debt terms as an exchange of the old debt for a new one. The lender may have a gain or loss on the exchange, depending on what the debt is worth at the time of the exchange in relation to his tax basis in it. The borrower may also have tax consequences.

IRS regulations take the position that a mere change in obligor on a recourse debt is a significant modification of the debt that triggers these tax consequences. The analysis for a nonrecourse debt is more complicated.

Companies today can change their US tax classifications simply by filing a form with the IRS. For example, a company treated as a corporation might – by filing a form – turn itself into a “disregarded entity.” It then ceases to exist for tax purposes. If the company has borrowed money, this change in classification means that a different entity is suddenly the borrower on the loan. The tax consequences are easy to overlook.

Keith Martin