It is an unfortunate reality that as the economic repercussions of the COVID-19 pandemic continue to be felt, companies — even those that were performing quite strongly at the start of 2020 — will face significant headwinds, if they haven’t already. Many may need to consider some sort of restructuring of their balance sheet and debt obligations to create a sustainable business model that positions them for success in 2021 and beyond.
Those companies that determine that restructuring is the best path forward need to understand, however, that it will not magically make all of their bills and tax obligations disappear. In fact, any time there is a foreclosure of assets, an exchange of assets for debt, or a reduction of debt, a taxable event is created. Failure to consider the tax implications of restructuring can create complex situations for a business, and bring serious risks to and unintended negative impacts on cash flow and liquidity.
One of the most important — and fundamental – things to consider during a restructuring is often the most overlooked: the type of entity that is being restructured. In a restructuring, tax liabilities are often passed up to the owners of LLCs, partnerships, or individuals, depending on the entity’s makeup. And, since a restructuring always creates a taxable event, stakeholders must carefully consider where the tax liability goes and how it may impact them.
With a standalone C-corporation, for example, taxable circumstances may be contained or they may have implications upstream if the company is owned by another company. With more common multi-layered LLCs, partnerships or subchapter S-corporations, the tax obligation could pass through to an individual taxpayer. On the other hand, if the entity is a subsidiary that is part of a holding company along with other entities, things can become even more complicated. Tax liabilities in this instance could actually be one level removed, and would need to be addressed in a consolidated return filed for that holding company.
All of this is to say that the legal structure of the business being restructured has a much bigger impact than many executives realize and account for.
Another area that needs careful focus is the myriad ways a taxable transaction can cause liquidity issues. During a restructuring, companies may try to offload assets to save money and reduce debt. However, it is a common misconception that taxes can be avoided if no cash is exchanged during a transaction such as a foreclosure on assets or an exchange of debt. Any time income is created, it is axiomatic that a taxable event has occurred and any tax liability from these transactions falls directly to the business or to whichever entity is paying the taxes.
The amount of debt forgiveness, from a tax point of view, can be viewed as taxable income.
Cancellation of debt income (CODI) is another commonly misunderstood aspect of restructuring that can have a significant impact on liquidity. When a restructuring occurs, whether in bankruptcy court or out-of-court, it often results in excess debt being forgiven. The amount of that debt forgiveness, from a tax point of view, can be viewed as taxable income.
For many businesses, however, CODI is a double-edged sword. For instance, if a business has CODI, it can claim insolvency in order to address current tax obligations. However, the company can still have significant tax implications through the reduction of tax attributes such as tax-loss carryforwards. If CODI exceeds tax attributes, the excess can also reduce the tax basis in assets, resulting in lower deductions to offset future taxable income.
Lenders may think they are solving a problem by canceling debt and creating a restructured balance sheet or capital structure with lower interest costs for a borrower facing stress or distress. But, before they consider any restructuring, it is important to evaluate tax implications of that canceled debt. Even if the tax resulting from restructuring may not necessarily be a current obligation, it can have a significant impact on future cash flow. In fact, it can considerably reduce the tax attributes of the surviving entity, making tax payments going forward much higher than they would be in a traditional financial calculation of taxable income.
While little is certain about how the U.S. economy will rebound from COVID-19, it is clear that for many companies, the crisis has permanently challenged assumptions and forecasts about their financial stability. As they consider restructuring or other changes to their financial and operational structures to stay viable in this “new normal,” tax implications should never be an afterthought. Having a clear picture at the outset of a restructuring will help assure that taxable events are not created unknowingly, and will position the company for a more favorable outcome. In order to have a complete picture, appropriate restructuring and tax professionals with experience in the implications of cancellation of debt should be consulted. The company should seek their input early in the process to develop an appropriate path forward.
Jette Campbell is a Partner at Carl Marks Advisors, a New York-based investment bank that provides financial and operational advisory services. He can be reached at [email protected].