Discharge of indebtedness: conversion vs. contribution of indebtedness.

• Author: Sekhri, Vikas

As a result of the credit crunch and economic slowdown, an increasing number of businesses are facing difficulties in meeting the payment obligations on their indebtedness. In an effort to de-leverage, more and more creditors, particularly those also holding an equity position, are willing to accept repayment for less than the face amount of the debt. Apart from settling the debt in cash for less than its face value, there are other methods debtors and creditors may use to modify, reduce, or even eliminate debt. Depending upon the method, the tax implications may vary.

In general, satisfaction of debt for less than its adjusted issue price (within the meaning of Regs. Sec. 1.1275-1(b)) generates cancellation of debt (COD) income. This item addresses the federal income tax implications for debtors and creditors where:

1. A shareholder-creditor (or partner) contributes a debt obligation of the debtor corporation (or partner ship) as a contribution of capital; or

2. The debtor corporation (or partnership) converts the debt owed to a creditor into stock (or a partnership interest).

This item is limited in scope to the above issues and will not address the application of the Sec. 108(a) COD exclusions for insolvent corporations and corporations in bankruptcy or similar proceedings.

Capital Contribution of Corporation's Indebtedness: Sec. 108(e)(6)

Sec. 108(e)(6) overrides the provisions of Sec. 118 (which exclude contributions of capital from the gross income of the corporation) and provides that a capital contribution by a shareholder of the corporation's own debt is treated as if the debtor corporation satisfied the debt with an amount of money equal to the shareholder's adjusted basis in the debt. Thus, if the shareholder-creditor's basis in the contributed debt is at least equal to the adjusted issue price of the debt, the debtor corporation will avoid COD income upon contribution of such debt. However, if the shareholder's basis in the debt is less than the adjusted issue price of the debt, the debtor corporation will recognize COD income.

Example 1: Corporation D owes $100 to C, the sole shareholder of D. The adjusted issue price of the debt and C's basis in the debt equal $100. In order to meet certain debt covenants related to outstanding third-party debt, C contributes the debt to capital. C's contribution of the debt to capital does not trigger COD income to D because C's basis in the contributed debt is equal to the adjusted issue price of the debt.

In situations in which the shareholder contributing the debt is not the sole shareholder, compensation and gift issues may arise if the benefiting shareholders are employees or are related to the contributing shareholder.

Special Rule for S Corps.

Under Sec. 1367(b)(2), if an S corporation is indebted to a shareholder, the shareholder's basis in the debt is reduced for excess losses deducted by virtue of Sec. 1366(d)(1)(B). If the shareholder later contributes such debt to the S corporation, absent any provision to the contrary, the COD income of the S corporation would be computed with reference to the shareholder's reduced basis in the debt. In order to prevent this outcome, Sec. 108(d) (7)(C) provides that...