Interest deductions for bankrupt corporations.

• Author: Potter, William W.

At the end of a business cycle, the tax laws related to bankruptcy play a critical role for troubled companies that must restructure balance sheets or liquidate assets. Often, general tax rules do not apply and are superseded by arcane rules that attempt to recognize the economic reality for each troubled company. Under chapter 11 of the Bankruptcy Code, a company can petition a bankruptcy court to continue its operations by restructuring its debt and equity under the aegis of bankruptcy laws. The troubled company's reorganization almost always results in the reduction of unsecured creditors' claims.

A practical issue that arises for a company in bankruptcy is whether post-petition interest is deductible. Additional interest deductions may lower taxable income, if any, or increase a company's net operating loss (NOL). This issue of how to treat interest deductions for corporate debt in bankruptcy was most recently addressed by the bankruptcy court in In re Dow Corning Corp., 270 BR 393 (DC MI, 2001).

Interest Deductions

Generally, Sec. 163 allows taxpayers to deduct "all interest paid or accrued within the taxable year of indebtedness." According to Sec. 7701 (a)(25), the term "paid or accrued" means "according to the method of accounting upon the basis of which the taxable income is computed." Therefore, the proper time for deducting interest depends on the taxpayer's method of accounting.

Because of Sec. 448, most C corporations are accrual-method taxpayers. Under the accrual method (as set forth in Sec. 461(h)), a taxpayer incurs a liability when it meets the "all events test," under which "the fact of liability and the amount of such liability can be determined with reasonable accuracy." As a general rule, the all-events test is not met earlier than when economic performance occurs. For interest, economic performance occurs with the passage of time. Therefore, interest deductions are appropriate in the year in which the taxpayer accrues interest, rather than the year it pays the interest.

The IRS's central and most successful argument in denying a corporate taxpayer in bankruptcy an interest deduction is its claim that the "fact of the liability" has not occured. In other words, the interest deduction is not fixed and determinable. The IRS supports this point by asserting that the interest is contingent because the corporate taxpayer is insolvent. However, a company's solvency is not a requirement of Sec. 163. Further, as discussed in Dow Corning, the legislative history of Sec. 163 "cannot be justified as reflecting the manifest will of Congress" imposing some kind of solvency requirement. However, prior case law, in certain circumstances, has held that solvency is a determining factor in whether a...