Distressed S corporations: tax issues involved in restructuring.

• Author: Karlinsky, Stewart S.

The recent economic downturn, coupled with the tightening of the credit market, is affecting all types of businesses, including S corporations. A financially distressed S corporation may have to work with its creditors to restructure debt or satisfy indebtedness in various creative ways in order to ease its financial difficulties. These transactions may include subordinating shareholder debt to a third-party loan, issuing stock to creditors, or soliciting additional capital contributions. This article highlights tax issues and planning opportunities that may arise relative to a distressed S corporation, its shareholders, and its creditors.

Cancellation of Debt

The general rule of income tax law is that if a taxpayer is relieved of or forgiven indebtedness, it will give rise to ordinary taxable income. (1) However, Sec. 108 lays out exceptions to this rule, such as cases in which the taxpayer is bankrupt under title 11, is insolvent, (2) or has qualified real estate indebtedness. The trade-off for this exclusion from income recognition is that certain taxpayer tax attributes such as net operating losses (NOLs), general business credits (GBCs), minimum tax credits (MTCs), or capital losses (C/Ls) must be reduced. Alternatively, the taxpayer may elect to reduce basis in depreciable assets. Note that the creditor is allowed a tax deduction for the loss even though the debtor may not recognize income.

Reorganizations

Another tax provision that often comes into play in debt restructuring is the E reorganization under Sec. 368(a)(1)(E). This rule allows an entity and its creditors and shareholders to restructure the liabilities and equity section of the balance sheet. Some common applications of an E reorganization are converting debt to equity to avoid violating loan covenants or moving shareholder debt from senior to junior status to raise cash. These transactions may be done without triggering recognized gain.

Another application of the E reorganization is to take advantage of a bad situation. For example, if a C corporation's asset values are close to their adjusted basis, the taxpayer might make an S election with minimal Sec. 1374 built-in gain exposure. If an S election is made, a recapitalization might be necessary to eliminate preferred stock or class B common stock, because an S corporation is allowed only one class of stock. Neither the shareholder nor the corporation will incur a recognized gain. An E reorganization (recapitalization) is preferable to redeeming the prohibited stock...