Corporate cancellation of debt relief.

• Author: Elliott, Eric R.

The recent economic downturn coupled with the tightening of the credit market has forced many financially distressed corporations to renegotiate the terms of their maturing debt obligations. As little as 12 months ago, these companies would have been able to refinance their maturing debt with slightly higher credit terms or simply would have received an extension on their original agreement.

Unfortunately, today's creditors are facing the harsh reality that they must demand payment from debtors under the original terms outlined in the credit agreement or face the possibility of receiving none of the principal and interest due at the date of maturity. Many subordinated debt holders have been eager to offer substantial settlements in lieu of extending credit terms or refinancing for fear that the current economic downturn is here to stay. In addition to allowing the creditor to retrieve some of its original investment, this cancellation of debt can be a substantial windfall to a debtor company on the verge of financial collapse.

The Code's general rule considers cancellation of debt (COD) income under Sec. 61(a)(12). However, Sec. 108 provides some relief to the financially distressed beneficiaries of these debt cancellation offers. The relief provided under Sec. 108 depends on the debtor's financial viability and the terms of the COD settlement.

Discharge of Indebtedness by Insolvent Taxpayer

Sec. 108(a) excludes from gross income COD income if the discharge occurs in a Title 11 (bankruptcy) case (Sec. 108(a)(1)(A)) or when the taxpayer is insolvent (Sec. 108(a)(1)(B)). It should be noted that under Sec. 108(a)(3), the amount of the exclusion under the insolvency exception of Sec. 108(a)(1)(B) will be limited to the excess of the debtor company's fair market value (FMV) of its liabilities over the FMV of its total assets.

It should also be noted that determining the company's FMV may be a difficult task. Many credit deals are renegotiated at the brink of financial collapse, and substantiating corporate FMV will likely require the assistance of third-party valuation experts. The use of these experts may require a significant amount of time and financial resources, neither of which the company may have.

In either insolvency or bankruptcy, the amount of COD income excluded will result in a reduction of the company's tax attributes by the exclusion amount. Once the excluded COD has been determined, the amount excluded shall be applied to reduce...