Tax Consequences from Discharging Debt
By Richard M. Leder and David Danon
The Internal Revenue Service issued regulations in late August that clarify what happens when a corporation that is in bankruptcy is released from some of its debts.
The government was unhappy with a tax position that the giant long-distance telephone company Worldcom — now called MCI — claimed in a plan the company presented to a bankruptcy court. The regulations bar other companies from taking the same position. However, at the same time, they contain some welcome news for distressed power companies.
Ordinarily when a company is released from some or all of its debts, it must report the amount relieved as “cancellation of debt,” or “COD,” income. However, section 108 of the US tax code lets any company whose discharge occurs in a chapter 11 bankruptcy proceeding or otherwise when the company is insolvent avoid reporting the discharged amount as income. (In the case of a company that is merely insolvent, this rule applies only to the extent the company is insolvent.) Instead, the company must reduce certain tax attributes by the discharged amount. For example, if it was discharged from $100 million in debt and has $100 million in net operating loss carryforwards, the loss carryforwards would be eliminated as the tradeoff for not having to report any COD income.
Section 108 has a list of tax attributes that the discharged amount must be used to offset. Complications arise when the debtor corporation that was discharged joins with other companies in filing a consolidated — or group — income tax return.
The new IRS regulations in August clarify the manner in which the attributes of a consolidated group and its members must be reduced as a result of the realization of COD by a member of the group that is in bankruptcy.
Under the new regulations, consolidated groups with bankrupt members that have COD income in many cases will not be able to insulate tax attributes of other companies in the group from reduction.
The principal attributes that are reduced are net operating losses, or “NOLs,” tax credits, capital losses and asset bases — largely in that order of priority.
Any reductions in asset basis (which occur at the beginning of the next tax year after the discharge) are subject to the limitation that the reduction cannot reduce the aggregate tax bases that the debtor corporation has in all of its assets below the level of the debtor’s remaining indebtedness immediately following the discharge. Reductions in asset basis occur in the following order: 1) buildings and other real property used in a trade or business or held for investment, other than inventory property, that secured the debt giving rise to the COD income, 2) personal property used in a trade or business or held for investment, other than inventory property, that secured the debt giving rise to the COD income, 3) any remaining property used in a trade or business other than inventory, accounts receivable, notes receivable and real property that is inventory property, 4) inventory, accounts receivable, notes receivable and real property that is inventory property, and 5) property not used in a trade or business or held for investment.
Any COD that does not in fact lead to attribute reduction under these rules simply disappears.
COD realized by a member of a consolidated group is determined on an entity-by-entity basis.
Before the new regulations, whether attribute reduction occurred on a separate entity or consolidated approach was unclear. The IRS had ruled that a group’s entire consolidated net operating loss was reduced by a debtor member’s COD, not just the portion of the consolidated NOL attributable to the debtor corporation that had the COD income. A US Supreme Court decision in a case involving United Dominion, although dealing with a different issue involving special carryback rules for product liability losses, was viewed as lending support to that position. The IRS had also issued rulings to the effect that only the debtor corporation’s asset bases were subject to reduction, a view universally believed by tax lawyers to be correct (although the IRS expressly raised doubt as to correctness of this position in the ruling referred to earlier).
WorldCom and the members of its affiliated group file consolidated income tax returns. The company is currently in bankruptcy. The WorldCom group’s COD income is reportedly in one or more holding companies while the group’s NOLs are principally attributable to operating subsidiaries. Worldcom took the position in the plan it presented to the court for emerging from bankruptcy that only the portion of the consolidated NOL attributable to the holding companies and the bases of the holding companies’ assets, which consisted primarily of the stock of their subsidiaries, had to be reduced. WorldCom did not plan to reduce the consolidated NOL to the extent attributable to group members other than the particular holding companies that had the COD income.
New IRS Position
The new IRS regulations adopt what might be called a “hybrid consolidated approach” to COD attribute reduction for a consolidated group.
Under the regulations, attribute reduction is first applied to the debtor corporation with the COD income; the attributes of that member are reduced under the ordering rules described earlier, and the attributes of other members are initially ignored.
If attribute reduction of the debtor corporation with the COD income results in a reduction in basis of subsidiary stock held by the debtor corporation, then the COD and required attribute reduction will tier down the ownership chain from the COD member. This tier down will occur layer-by-layer because if all or a portion of the COD member’s attribute reduction is a reduction in the basis of the stock of a subsidiary, then the amount of the reduction in that subsidiary’s stock will tier down to become deemed COD of that subsidiary. The attribute reduction rules will apply at the level of that subsidiary in the same way as with the COD member, starting with such subsidiary’s share, if any, of consolidated NOLs. For each entity going down the chain, the attribute reduction follows the same separate entity approach.
Example 1: P owns 100% of the stock of Sub1. Sub1 owns 100% of the stock of Sub2 and Sub2 owns 100% of the stock of Sub3. P, Sub1, Sub2 and Sub3 file a consolidated federal income tax return. Sub1’s basis in Sub2 equals $100, and Sub2’s basis in Sub3 is $50. The P group has a $150 consolidated NOL, $50 of which is attributable to each of Sub1, Sub2 and Sub3. Sub1, Sub2 and Sub3 have no other tax attributes and no liabilities. Sub1 has $150 of COD.
As a result of Sub1’s $150 of COD, first Sub1’s $50 NOL will be eliminated, then its $100 basis in Sub2 will be reduced to $0. As a result of the $100 reduction in the basis of its stock Sub2 will be deemed to have $100 of COD income. This deemed COD income will eliminate Sub2’s $50 NOL and will reduce Sub2’s basis in its Sub3 stock from $50 to $0. As a result of the $50 reduction in the basis of its stock, Sub3’s NOL will be eliminated.
If the COD member has sufficient attributes to reduce to offset the member’s entire COD, then members outside the ownership chain below the COD member will have no attribute reduction. If the COD member does not have sufficient attributes to reduce, then the attributes of members outside the chain can have their attributes — other than asset basis — reduced.
Example 2: Same as Example 1, except 1) P also owns 100% of the stock of Sub4, 2) Sub4 owns 100% of the stock of Sub5, 3) the group consolidated NOL is $200 of which $50 is attributable to Sub5, and 4) Sub1 has $250 of COD.
As in Example 1, $150 of Sub1’s COD reduces Sub1’s NOL and tiers down to reduce Sub2 and Sub3 stock basis, and the $50 of the consolidated NOL attributable to each of these group members. Since Sub1’s attributes have been fully reduced and $100 of COD remains, $50 of the remaining $100 of Sub1’s COD that does not reduce its attributes reduces the $50 Sub5 NOL. The remaining $50 of COD does not reduce any other attributes of the group, such as P’s basis in Sub1, or Sub4 or Sub4’s basis in Sub5, and is eliminated.
The rule that asset reduction cannot reduce aggregate asset basis below the level of the particular corporation’s debt level is applied separately at each level. Furthermore, while COD of a group member is generally available to reduce consolidated attributes of other members after tax attributes of the COD member have been exhausted, deemed COD of a member resulting from a reduction in the basis of its stock will not reduce the tax attributes of any other member of the group (except through tiering down of its deemed COD).
Example 3: Same as Example 2, except 1) Sub1 has liabilities of $20, 2) Sub2 has liabilities of $50, 3) the group consolidated NOL is $150 of which $50 is attributable to each of Sub1, Sub2 and Sub5, and 4) Sub1 has COD of $150.
As in Example 2, $50 of Sub1’s $150 of COD eliminates Sub1’s $50 NOL. However, because Sub1 has only $80 of asset basis in excess of liabilities, only $80 of Sub1’s remaining $100 of COD reduces Sub1’s basis in Sub2 stock. Sub1’s remaining $20 of COD reduces Sub5’s NOL by $20 to $30.
As in Example 2, Sub2’s $50 NOL is eliminated as a result of the reduction in the basis of its stock. However, because Sub2 has no excess of asset basis over liabilities, no portion of the remaining $30 of deemed COD income reduces Sub2’s basis in the stock of Sub3. Furthermore, since Sub2’s COD is deemed COD resulting from a reduction in basis of its stock, its excess $30 of COD does not reduce Sub5’s NOL.
Before the latest IRS regulations, a reduction in the basis of a subsidiary’s stock did not require the reduction to tier down to the subsidiary’s attributes.
Example 4: Same as Example 1, except 1) the consolidated NOL is $50, of which all $50 is attributable to Sub1, and 2) Sub3 has a basis in its operating assets of $50.
As in Example 1, $50 of Sub1’s COD reduces Sub1’s NOL and the remaining $100 of COD reduces Sub1’s basis in Sub2. However, Sub2 does not have deemed COD as a result of the reduction in the basis of its stock and therefore Sub2 is not required to reduce its attributes as it is in Example 1. Therefore, Sub2’s basis in Sub3 is not reduced and Sub3’s basis in its operating assets is not reduced.
Effect on Worldcom Plan
Under the new regulations, each member of the WorldCom consolidated group that has COD income will have to reduce basis in the stock of its subsidiaries. The NOLs of these subsidiaries and the NOLs of any other subsidiaries further down this holding company’s ownership chain will also be reduced to the extent of the COD.
If this tiering down of COD from a WorldCom holding company does not fully exhaust the WorldCom holding company’s COD, then the excess COD will reduce consolidated NOLs attributable to other WorldCom operating companies whose holding companies do not have sufficient COD to eliminate the portion of the consolidated NOL attributable to those members beneath them in the WorldCom ownership chain. However, deemed COD of a WorldCom member that results from tiering down of COD from a WorldCom COD member will not reduce the portion of WorldCom consolidated NOLs that are attributable to other members (except through a tiering down of the member’s deemed COD). This will result in a reduction of the WorldCom consolidated NOL (and perhaps the basis of WorldCom operating assets), rather than the hoped for reduction in stock basis of subsidiaries of COD members.
The change means there is probably less value in Worldcom than the company claimed in the plan the company presented to the bankruptcy court.