When a business enters Chapter 11 reorganization, it faces not only legal and operational hurdles but also complex tax issues. It is essential for companies to understand IRC Sections 108 and 382 so they can anticipate and manage the tax effects as they navigate bankruptcy.
When a business enters Chapter 11 reorganization, it faces not only legal and operational hurdles but also a complex set of tax issues. The Internal Revenue Code (IRC) provides specific provisions – particularly IRC Sections 108 and 382 – that can significantly impact the tax attributes and future profitability of the reorganized entity. Understanding the interplay between these sections is crucial for minimizing adverse tax consequences and maximizing future tax benefits.
A successful bankruptcy process culminates with a well-structured, court-approved plan that aims to provide the troubled business with a fresh start. The plan often involves debt modification or cancellation, transfers of stock or assets in partial satisfaction of debt, and internal restructuring. While these steps are intended to restore financial health, they also may give rise to sometimes unexpected tax consequences that may run counter to the goal of a fresh start. The complex rules of IRC Sections 108 and 382 present both opportunities and pitfalls, making it essential for companies to anticipate and manage the tax effects as they navigate bankruptcy.
Section 108
Troubled businesses frequently carry large amounts of debt that cannot be serviced with available cash flow, making debt resolution a central aspect of bankruptcy restructuring. Generally, the cancellation or forgiveness of debt – including, in certain circumstances, the modification of debt – results in cancellation of debt income (CODI), which is included in gross income under IRC Section 61(a)(11). However, IRC Section 108(a)(1)(B) allows insolvent taxpayers to exclude CODI to the extent of the taxpayer’s insolvency immediately before the debt discharge. For taxpayers in a Chapter 11 or similar case, IRC Section 108(a)(1)(A) excludes CODI from income and does not require the debtor to prove the extent of insolvency. However, under IRC Section 108(d)(2), the exclusion in IRC Section 108(a)(1)(A) applies only if the taxpayer is subject to the court’s jurisdiction and the discharge is either granted by the court or occurs under a court-approved plan.
Special attention is required for bankruptcies involving entities treated as flowthroughs (such as partnerships) or disregarded entities (such as single-member LLCs and grantor trusts). Under IRC Section 108(d)(6) and Treas. Reg. Section 1.108-9, the bankruptcy exception applies at the partner or regarded-owner level. Thus, a partner who is not under the jurisdiction of the court in a title 11 case may be required to recognize his or her distributive share of the partnership’s CODI. In such cases, the insolvency exception under IRC Section 108(a)(1)(B) may provide relief to the partner or regarded owner, but the rules for measuring insolvency (defined as liabilities exceeding the fair market value of assets under IRC Section 108(d)(3)) are complex and lack comprehensive IRS guidance.
Another potential trap arises when secured debt is discharged in exchange for the transfer of the collateral (or proceeds from the sale of collateral) to the creditors. The recourse/nonrecourse character of the underlying debt controls the tax treatment. For recourse debt (generally, in personam debt), the debtor recognizes gain or loss up to the fair market value of the property and CODI for any excess debt.1 For nonrecourse debt (generally, in rem debt limited to specific collateral), the debtor recognizes gain or loss based on the difference between the forgiven debt and the property's adjusted basis, even if the debt exceeds the collateral’s value.2 In the latter case, the gain is not CODI and cannot be excluded under the bankruptcy exception, though offsetting net operating losses (NOLs) or capital loss carryovers may mitigate the impact. Determining recourse versus nonrecourse status can be especially complex for partnerships and disregarded entities.
Bankruptcy proceedings involving consolidated groups introduce additional complexity. While beyond the purpose of this article, it is important to mention that excess loss account (ELA) rules may lead to CODI being unexpectedly recast such that it is not excluded as CODI and is instead included as gain recognized on the consolidated group’s return. In consolidated groups, the basis of members’ stock (excluding the parent) is adjusted for annual items of income and loss, similar to basis in partnerships and S corporations.3 This may result in negative stock basis or ELA when the subsidiary has ongoing losses. Triggering events – including the realization of CODI excluded from gross income and not treated as tax-exempt income for stock basis purposes – can activate ELAs, requiring income recognition to recapture negative stock basis.4
Even when all pitfalls are avoided and CODI is excluded from gross income under the bankruptcy exception, a trade-off remains: tax attributes must be reduced in an amount equal to the excluded CODI.5 This mechanism ensures that while the debtor avoids a current tax hit from discharged indebtedness, the ability to offset future taxable income is diminished, reflecting a deliberate policy choice to defer, rather than eliminate, the tax consequences of debt discharge in bankruptcy.6
The attribute reduction occurs after tax or loss is calculated for the tax year of discharge.7 Any excluded CODI in excess of attributes – the so-called “black hole CODI” – is ignored for all other tax purposes.
IRC Section 108(b)(2) provides the ordering rules for the attribute reduction:
- NOL carryovers
- General business credit carryovers
- Minimum tax credit carryovers
- Capital loss carryovers
- Tax bases of depreciable property
- Passive activity loss or credit carryovers
- Foreign tax credit carryovers
Attributes are generally reduced dollar-for-dollar for excluded CODI, except for tax credits, which are reduced by 33-1/3 cents for every dollar of excluded CODI. The tax bases of depreciable assets cannot be reduced below the so-called “liability floor” – the taxpayer’s total liabilities immediately following the debt discharge.8 As expected, in the consolidated groups context, additional rules must be considered when reducing tax attributes, both with respect to the movement of the attribute reduction within the group, and the impact of such rules on the members stock basis.9
IRC Section 108(b)(5) allows taxpayers to elect to first reduce the tax bases of depreciable property, limited to the aggregate basis at the start of the following tax year. This can be advantageous for taxpayers with long-lived depreciable assets who wish to maximize future NOL deductions, while those with short-lived depreciable assets may prefer to preserve tax basis and maximize depreciation deductions.
Section 382
After considering attribute reduction under IRC Section 108, particularly the trade-off between future NOL deductions and maximizing depreciation, taxpayers must address loss limitation rules. IRC Section 382 generally limits the annual amount of NOLs and built-in losses that can be used following a more than 50% ownership change. The amount of the limitation is based on the product of the long-term, tax-exempt rate and the value of the loss corporation’s stock immediately before the change of ownership. Generally, the relatively low long-term tax-exempt rate and depressed stock value of the troubled corporation can significantly reduce the allowable annual loss limitation.
IRC Section 382(l)(5) provides a default rule for corporations emerging from bankruptcy, exempting them from the annual loss limitation if shareholders and certain qualified creditors of the old loss corporation – determined immediately before the ownership change – own, after the change at least 50% of the stock of the new loss corporation (or of a controlling corporation, if also in bankruptcy), as measured under the modified requirements of Section 1504(a)(2) (substituting “50%” for “80%”). However, NOL carryovers must be reduced by interest deductions claimed in the current and three previous years. A second ownership change within two years will eliminate the ability to use the NOLs entirely. To protect NOLs, bankruptcy plans should require creditors and shareholders to maintain their ownership percentages for at least two years.
Alternatively, corporations may elect out of IRC Section 382(l)(5) and apply IRC Section 382(l)(6), which allows the value of the corporation to be determined after the discharge of debt and avoids the interest deduction "haircut" to NOLs. This election may be beneficial for debtor corporations unable to obtain a two-year lockup agreement among shareholders and creditors or those facing significant haircuts to NOL carryovers. The IRC Section 382 limitation generally allows the limitation to be computed by reference to the debtor’s gross assets immediately before the ownership change or net equity value immediately after the ownership change, whichever is lower. The election is irrevocable and must be made on the loss corporation’s tax return for the year of change. Taxpayers making an IRC Section 382(l)(6) election can also choose whether to first reduce NOL deductions or depreciable asset bases, which provides additional flexibility in tax planning.
Final Thoughts
Navigating the tax consequences of a Chapter 11 reorganization requires careful planning and a thorough understanding of the complex interplay between IRC Sections 108 and 382. Attribute reduction rules and loss limitation provisions may restrict the ability to use valuable tax benefits such as NOLs and built-in losses, especially following ownership changes. By proactively analyzing the available options, factoring in the anticipated timeline to profitability, and evaluating the value of depreciable assets and NOLs, taxpayers can make informed decisions that optimize their post-bankruptcy tax position. Ultimately, a thoughtful and strategic approach to these tax rules is essential to ensure that the reorganization achieves its goal of restoring financial health and setting the stage for future success.
1 Treas. Reg. Section 1.1001-2(c), example 8.
2 Treas. Reg. Section 1.1001-2(c), example 7; Commissioner v. Tufts, 461 U.S. 300 (1983).
3 Treas. Reg. Section 1.1502-32.
4 Treas. Reg. Section 1.1502-19.
5 IRC Section 108(b).
6 S. Rep. No. 96-1035, at 10 (1980).
7 IRC Section 108(b)(4).
8 IRC Section 1017(b)(2).
9 Treas. Reg. Section 1.1502-28; Treas. Reg. Section 1.1502-32.
Kevin Wilkes, JD, LLM, is a tax principal in the Transaction Advisory Services office at BDO USA PC. He advises clients on a wide range of tax matters, including business formation, restructuring, acquisitions, dispositions, and managing tax attributes. Before joining BDO in West Michigan, Wilkes led the tax practice at a regional firm in Pittsburgh and held a senior M&A tax role at a Big Four firm. He can be reached at kwilkes@bdo.com.
Alina Pierce, CPA, LLM, is a Tax Experienced Manager in the Washington National Tax office at BDO USA PC, specializing in M&A transactions, restructuring for troubled corporations, debt resolution, and a broad range of complex tax matters. Prior to joining BDO, Pierce worked at a regional South Florida public accounting firm, where she developed a strong foundation in tax compliance and client service. She can be reached at atpierce@bdo.com.
Sign up for PICPA's weekly professional and technical updates by completing this form.
Statements of fact and opinion are the author's responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.
