Measuring insolvency for sec. 108 purposes: suggested valuation guidelines.

• Author: Abahoonie, Edward J.

The convergence of marketplace conditions and changes in the tax law has heightened the importance of the definition of insolvency under Sec. 108(d)(3). Excessive debt undertaken by companies in the heated mergers and acquisitions market of the 1980s, coupled with declining growth, has resulted in a huge increase in debt restructurings. it has become common for companies to partially or entirely retire debt at a discount to its carrying value (or "adjusted issue price")--this can involve a cash repayment, renegotiation of existing debt terms, issuance of new securities or stock, or some combination thereof.

Debt restructurings, both in bankruptcy proceedings and out of court, have become more common. At the same time, tax law changes have largely confined the opportunity to defer or eliminate recognition of cancellation of debt (COD) income outside of bankruptcy to "insolvent" companies and have expanded the occasions on which taxpayers will realize COD income. The Revenue Reconciliation Act of 1990 repealed Sec. 1275(a)(4), which had effectively prevented the realization of COD income in recapitalization debt-for-debt exchanges. Similarly, the Revenue Reconciliation Act of 1993 repealed the Sec. 108(e)(10) stock-for-debt exception, causing taxpayers to realize COD income even more frequently. Troubled companies will now often realize COD income when debt is renegotiated or new securities or stock is issued (in whole or in part) to retire old securities.

Current tax law provides incentives for a company to file for bankruptcy. For example, a corporation in bankruptcy with net operating loss (NOL) or credit carryforwards has more flexibility in mitigating the tax consequences of Secs. 382 and 383 than an insolvent corporation that undergoes an ownership change outside of bankruptcy (or a similar court proceeding). Likewise, G reorganizations are only available to taxpayers in a Title 11 or similar case.

A taxpayer that restructures debt may be encouraged to file for bankruptcy, because all COD income will be excluded under Sec. 108(a)(1)(a). In contrast, under Sec. 108(a)(1)(b) and (a)(3), an insolvent taxpayer that restructures its debt outside of bankruptcy may only exclude COD income to the extent of its insolvency.

This framework nonetheless reflects Congress's intent to provide insolvent taxpayers with limited relief from current taxation of COD income. Depending on the extent of insolvency and magnitude of COD income, the tax relief intended for insolvent taxpayers under Sec. 108 could equal that provided to taxpayers in bankruptcy. Current uncertainty regarding the definition and measurement of insolvency, however, renders the insolvency exception ineffectual and exacerbates the discrepancy between the tax treatments of debt restructurings in and out of bankruptcy.(1)

Companies undergoing debt restructuring are almost always experiencing serious financial and operating difficulties, and are often incapable of funding a sudden tax burden resulting from a debt reduction. If the degree of tax relief is uncertain or unreliable, such businesses are forced to pursue bankruptcy, if possible. In turn, bankruptcy can cause an insolvent company to incur certain costs that it might otherwise avoid, including significant accounting and legal costs. Bankruptcy proceedings can also be cumbersome and time-consuming, thereby exacerbating an already troubled situation. In addition, companies are unfairly disadvantaged by a tax system that favors bankruptcy, because a bankruptcy filing is generally unduly harmful for business or legal reasons.

Many insolvent companies may be able to restructure their debt without incurring the costs and burdens of a bankruptcy filing. However, companies are often reluctant to undertake such a restructuring, because the tax costs are uncertain if the restructuring takes place outside of bankruptcy. This situation is contrary to legislative intent and inconsistent with the policy of tax neutrality in the making of business decisions. This article suggests guidance that should be provided by the IRS to resolve the uncertainty surrounding debt restructuring outside of bankruptcy.

What Is Insolvency?

Generally, Sec. 108(a)(1) provides for the exclusion of COD income if the discharge occurs in a Title 1 1 case or, if the taxpayer is insolvent, to the extent of insolvency. Sec. 108(d)(3) defines "insolvent" as the excess of liabilities over the fair market value (FMV) of assets as determined immediately before the discharge. "FMV" is not defined by the Code. The generally accepted definition of FMV, found in Regs. Sec. 20.2031-1(b), is the price at which property would change hands between a willing buyer and a willing seller, both being adequately informed of the relevant facts, and neither being under any compulsion to buy or sell. The key issue is the appropriate method of determining the FMV of assets and liabilities of an insolvent taxpayer.

* Background

The judicial insolvency exception evolved from a line of cases beginning with Kirby Lumber Co.,(2) in which the Supreme Court held that income was realized when a debt was discharged for less than the full face amount. In Dallas Transfer Terminal Warehouse Co.,(3) the Fifth Circuit held that no income was realized from the discharge of debt when the debtor was insolvent both before and after the discharge. Income was not realized because no assets were freed from the claims of creditors. The "freeing up of assets" approach remains relevant today, as the legislative history of the Bankruptcy Tax Act of 1980 (BTA) states that the BTA is a codification of the judicially developed insolvency exception.(4) The legislative history of the BTA indicates that Congress intended to follow the Bankruptcy Code in determining a taxpayer's insolvency.(5)

The definition of insolvency under Sec. 108(d)(3) is similar to the definition under the Bankruptcy Code. Bankruptcy Code Section...