Debt restructurings in today's private equity environment.

• Author: Keller, Brian E.

Most who work in the private equity arena agree that deal flow today is far from what it was just one year ago. However, those deals that are taking place today seem to bring with them many technical tax considerations that are seen much less frequently during robust economic times. Consider the case illustration below, which is a basic framework increasingly common in today's environment.

The target group is a federal consolidated chain composed of parent corporation P, which owns all the stock of subsidiary corporation S. P is a holding corporation and S is a large manufacturer with all the active business operations of the group. P is wholly owned by Seller, a single-member LLC, in turn wholly owned by a private equity fund, SF. SF is a large, diversely held limited partnership (i.e., no five or fewer persons own more than 50%) engaged in long-term investing and primarily dedicated to the capital appreciation of its underlying investments. SF is a typical leveraged buyout (LBO) fund widely held by a multitude of U.S. taxable, tax-exempt, and foreign investors. Buyer will be an entity of choice (an LLC or corporation) wholly owned by another LBO fund (BF) very similar to, although entirely unrelated to, SF.

Seller has $20 million of equity in, and $40 million of sub-debt lending to, P. All this $60 million has made its way into S, so P has a basis in S of $60 million. The equity and the lending have been in place for years. Further, Seller is guarantor on $20 million of unrelated third-party first-lien debt at the level of S. Buyer and Seller have generally agreed that Buyer will buy 100% of the common equity of P and Seller's $40 million note for one dollar. Seller will simultaneously make a $10 million infusion into S in exchange for a preferred interest that it will retain, and Seller's $10 million infusion will be used to repay half of the S first-lien debt, at which point the third-party lender will entirely release Seller from its guarantee. The group has an August tax year; for the sake of illustration, assume this transaction will close during this month (September).

At its year ended August 2009, the group has $20 million of net operating losses (NOLs) (all at the level of S; ignore any portion attributable to P from interest expense on the sub-debt, for instance) to carry forward (there is no carryback potential under current law), and S's tax basis balance sheet shows no cash; accounts receivable of $10 million; inventory of $20 million; net property, plant, and equipment (PPE) of $5 million; and the first-lien debt of $20 million. Assume no other assets, liabilities, or debt for purposes of this illustration. Further assume that there are no excess loss accounts or deferred intercompany transactions that would complicate this illustration.

Sub-Debt Elimination

Assume that de-levering the group (to ensure its survival) is a requirement of Buyer and that Seller has no expectation of collecting on any part of its $40 million note (hence its willingness to sell the note with the equity of P for some part of one dollar). The group clearly cannot repay the $40 million, and Buyer has no expectation of collecting on its recently acquired note. Hence, the $40 million obligation will be eliminated in some fashion. The first issue for evaluation might be whether the group has cancellation of debt (COD) income and, if so, what its tax impact is.

Sec. 108(e)(4) provides that, for purposes of determining the debtor's income from discharge of indebtedness, the acquisition of outstanding indebtedness by a person bearing a relationship to the debtor specified in Sec. 267(b) or Sec. 707(b)(1) from a person who does not bear such a relationship to the debtor shall be treated as the acquisition of such indebtedness by the debtor itself. Immediately before the proposed transaction, Buyer is of course unrelated to P. However, immediately after, Buyer is related, and this Sec. 108(e) (4) "relatedness" issue becomes potentially relevant via the Regs. Sec. 1.108-2(c)(3) six-month presumption that the indebtedness was acquired in anticipation of becoming related.

However, one can question whether Buyer must be one single newly formed acquisition vehicle to acquire Seller's stock and debt. For instance, BF might form a separate wholly owned Buyer corporation to acquire Seller's equity interest that will sit sister to another newly formed separate and "unrelated" wholly owned Buyer corporation to acquire Seller's $40 million sub-debt note. (For a thorough discussion of the various potentially applicable "relatedness" Code sections with respect to these two corporations (e.g., Secs. 267, 707, and 414), see Keller, Tax Clinic, "Transactions Between Private Equity Fund-Owned Portfolio Corporations: An Update," 39 The Tax Adviser 568 (September 2008)).

Assuming BF might have decided that it can structure around relatedness of the Buyer so as to avoid the reach of Sec. 108(e)(4), the statutory language is clear that although the acquirer of the outstanding indebtedness must be related to the debtor, the seller must not be. In the instant case, Seller is related to P under Sec. 267. As such, although Buyer's technical considerations of its own relatedness to P are interesting, they are irrelevant in this illustration because Seller is in fact related to P. Sec. 108(e)(4) simply does not operate here.

Sec. 108(e)(4) aside, Buyer must nonetheless de-lever the group. A simple discharge by Buyer triggers COD income. So what else might Buyer consider here to remove the sub-debt but at the same time avoid the associated COD income? Sec. 108(e)(6) provides that, for purposes of determining the debtor's income from discharge of indebtedness, if a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital, that...