Debt modification issues for LLCs.

• Author: Ellentuck, Albert B.
• Position: Limited liability companies

LLCs must be wary of the potential for taxable income arising from modifications, reacquisitions, forgiveness, and related-party transactions involving the company's debt.

Cancellation-of-debt (COD) income can arise from the modification of an existing debt instrument. Practitioners should be familiar with the COD rules to ensure that modifications of a limited liability company's (LLC's) debts are not significant enough to cause the members to recognize COD income.

If a new debt instrument is issued in satisfaction of existing debt, the new debt is treated as having paid off the existing debt with an amount of money equal to the issue price (determined under the original issue discount (OID) rules of Secs. 1273 and 1274) of the new debt instrument. Significant modification of the terms of a debt instrument (e.g., a change in interest rate) is considered an exchange of the old debt for new debt (Regs. Sec. 1.1001-3(b)). The issue price of the new debt generates debt forgiveness income if its issue price is less than the balance of the old debt (Sec. 108(e)(10)).

Under the OID rules for nonpublicly traded debt, if the new debt has an interest rate at least equal to the applicable federal rate (AFR), the issue price of the debt is its stated principal amount (Sec. 1274(a)(1)). Accordingly, when the only modification of a debt instrument is lowering the interest rate, and the lowered rate is at least equal to the AFR, the restructuring will not result in COD income. However, if the interest rate is less than the AFR, the imputed principal amount (generally, the present value of all payments required under the terms of the debt discounted at the AFR) becomes the issue price of the new debt, resulting in COD income (Sec. 1274(a)(2)).

Practice tip: A significant modification may be treated as an exchange of debt instruments resulting in the recognition of COD income. Regs. Sec. 1.1001-3 provides extensive discussion of what constitutes the significant modification of a debt instrument.

Sec. 1274(b)(3) contains a special rule that applies to a "potentially abusive situation." This rule says the imputed principal amount of the new debt instrument issued in consideration for the old debt instrument is limited to the fair market value (FMV) of property pledged to secure nonrecourse debt (as opposed to the stated principal amount of the debt instrument). Based on this rule, an exchange (or modification) of nonrecourse debt could produce significant COD income in a debt restructuring when the value of the secured property is less than the stated principal of the debt. An exchange (or modification) of an outstanding debt instrument for a nonrecourse debt instrument is not a potentially abusive situation solely by reason of the receipt of the nonrecourse financing (Regs. Sec. 1.1274-3(b)(1)). As a result, the imputed principal amount of the debt instrument issued in the exchange is not limited to the FMV of the property.

Deferral of Debt Forgiveness Income on the Repurchase of Debt

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