In the current economic environment, many borrowers struggle to make timely payments while other borrowers struggle to make any payments. Faced with the choice of receiving less than what is owed or none of what is owed, some lenders are renegotiating outstanding loans and granting lower interest rates, deferred payments, reduced principal, or other concessions. Transactions that used to occur infrequently, such as debt restructuring, debt forgiveness, and default, now take place more often. However, as illustrated by the examples below, these transactions often have tax implications that are not commonly known or considered.
For example, suppose Borrower defaults and is unable to pay the entire $1.5 million outstanding on its loan. Lender realizes it will not be able to collect the entire amount of the loan. Borrower and Lender negotiate a one-third reduction in the balance owed, to $1 million. Borrower, no doubt relieved to have avoided $500,000 of its liability, may be surprised to discover that it may now owe income tax on the $500,000 that was forgiven. Unless an exception applies in this case, Borrower recognizes $500,000 of taxable cancellation-of-debt, or “COD,” income.
Less substantial changes to the terms of loans or other debt instruments may also give rise to COD income to a borrower. For example, if Lender agrees to reduce Borrower’s interest rate from 8% to 6%, Borrower may recognize COD income calculated in a manner akin to the reduction in the present value of the note. Interest-free extensions of principal due dates can also reduce the present value of the note, similarly giving rise to COD income.
COD income may arise in other ways as well. For example, if Lender exchanges a $1,500,000 corporate note for Borrower’s stock with a fair market value of $1,000,000, other than as the result of exercising a conversion right that was in the note upon its original issuance, Borrower may recognize $500,000 of COD income. Existing shareholders who forgive corporate debt may also trigger COD income to the corporation. Similar nuances apply to debt issued by a partnership or S corporation.
However, there are some exceptions to COD income recognition. For example, a borrower that has filed for bankruptcy generally does not recognize COD income. To the extent that a borrower is insolvent, it may not recognize COD income. Instead, the borrower will recognize alternative tax consequences, such as reduced ability to deduct operating losses or to take advantage of tax credits. Special rules exist for purchasemoney debt, in some cases permitting a reduction in tax basis of the purchased asset as an alternative to the recognition of income. Other COD income exceptions exist for certain real property business debt, certain principal residence debt discharged before the end of 2012, and certain farm debt. A significant temporary COD income exception allows taxpayers to defer certain business COD income arising in 2009 or 2010. Foregiveness of debt may give rise to additional issues in a family setting. For example, if a parent forgives a loan to a child, the forgiven amount will generally be treated as a gift, and the child will not be taxed on the forgiven amount. However, the parent may have gift tax consequences. In an employment setting, if an employer forgives a loan to an employee, the employee must generally pay taxes, and the employer must withhold and pay employment taxes, as if wages were paid. Further analysis may be warranted in closely-held business settings where there may be family, employment, and other relationships.
If you would like more information on COD income, including COD income exceptions or planning to minimize COD income, please contact any other member of our Tax Group.