E&P issues/adjustments arising in connection with bankruptcy.

• Author: Blair, David W.
• Position: Earnings and profits

A significant number of bankruptcies occurred in the late 1980s as a result of overpriced and overleveraged acquisitions, a slow-down in economic growth in the United States and fierce competition in a global marketplace. While much attention has focused on the income tax and attribute preservation aspects of restructurings and bankruptcy (i.e., Secs. 108 and 382), less attention has been placed on peripheral issues such as earnings and profits (E&P). The E&P issue often becomes important in these restructurings when the rehabilitated debtor, typically sporting a substantially overhauled balance sheet, improves financially and commences paying dividends or is otherwise involved in a transaction in which the determination of E&P is relevant (e.g., reorganization involving a payment of boot, redemption or Sec. 355 distribution). Several of the more recurring and significant E&P issues/adjustments arising in connection with bankruptcy are often not focused on in connection with the determination of E&P after emergence from bankruptcy. These issues/adjustments may have a significant impact on the determination of E&P and should be carefully considered when performing and reviewing E&P calculations or when designing the capital structure of a rehabilitated entity, particularly if dividend-paying stock (i.e., preferred stock) is contemplated.

E&P reduction under Sec. 312(n)(7)

Sec. 312(n)(7) requires a reduction of E&P for the "ratable share" o the accumulated E&P attributable to the shares redeemed in a transaction subject to Sec. 302(a) or 303. Many leveraged buyouts (LBOs) during the 1980s were structured in such a way that a portion of the consideration would be considered a "redemption" under Sec. 302; see Rev. Rul. 78-250 or IRS Letter Ruling 8912049.

Example: An LBO group formed Newco with $100 of equity. Newco borrowed $900 to buy the stock of Target (with $500 of E&P). Immediately after the stock purchase and as an integral element of the financing conditions imposed by the lenders, Newco merged into Target. For tax purposes, the transaction (in effect) is treated as though 90% of the Target shares were redeemed, thus causing a 90% reduction in Target's E&P account (i.e., its E&P is reduced from $500 to $50).

Thus, in many cases involving LBOs with significant debt, a substantial reduction in E&P occurred at the closing of the acquisition. The impact of any reduction under Sec. 312(n)(7), adjusted for subsequently generated undistributed...