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

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 E&P (E&P deficit), is subject to any adjustments under Sec. 312(1) and/or Sec. 382(1)(5).

Sec. 312(1) adjustments

General rule: Sec. 312(1)(1) provides (by negative inference) that E&P is created from debt discharge income that is not applied to reduce basis under Sec. 1017. Thus, to the extent that debt discharge income is realized and the debtor is not reducing tax basis under the normal ordering rules of Sec. 108(b)(2) or the elective rule of Sec. 108(b)(5) (depreciable property only), E&P is realized. (Note: The basis reductions under Secs. 108 and 1017 for E&P purposes, however, would be with respect to the property's E&P basis.) Based on the legislative history of Sec. 312(1), the E&P amount so computed is used to reduce any E&P deficit that exists at the beginning of the tax year before creating current E&P (Rev. Rul. 75-515). This ordering rule may, for example, affect the characterization of income from "boot" in a tax-free reorganization under Sec. 356(a)(2).

Under the Sec. 108(b)(2) ordering rules, it is possible to reduce the basis of subsidiary stock as part of the attribute reduction requirement (without making a corresponding adjustment to the subsidiary's assets). As such, neither parent E&P nor separate subsidiary E&P is affected to the extent of such basis. Under the elective rule of Sec. 108(b)(5), the parent can make the basis adjustment to the stock of an affiliated subsidiary ("affiliate") (in lieu of depreciable basis) only if the affiliate consents to make a corresponding adjustment to the basis of its depreciable property (Sec. 1017(b)(3)(D)). The affiliate should treat this adjustment for E&P purposes as a reduction of its investment in its assets, thus, in effect, increasing E&P only through lower E&P depreciation deductions in subsequent years. These adjustments will be the same under both the current and proposed consolidated return rules (discussed later).

Under Regs. Secs. 1.1502-32 and -33 ("current consolidated return rules"), any E&P created by Sec. 312(1)(1) at the subsidiary level would "tier up" to the extent allocable to the owning member's interest in the subsidiary for determining E&P at the parent level (although the positive investment adjustment (Regs. Sec. 1.1502-32(b)(1)(i)) would be offset by a negative adjustment for any NOL "absorption" (Regs. Sec. 1.1502-32(b)(2)(ii))). Under Prop. Regs. Secs. 1. 1502-32 and -33 ("proposed consolidated return rules"), any E&P created by Sec. 312(1)(1) would "tier up" to the extent allocable to the owning member's interest in the subsidiary for determining E&P at the parent level (but given "delinking" from the basis rule, no negative adjustment would occur (i.e., no negative adjustment for E&P deficit previously "tiered up")).

Shareholder extinguishment rule: Sec. 312(1)(2) provides that if a shareholder's interest in a corporation is "terminated or extinguished" in the bankruptcy and there is a deficit in the corporation's E&P, the deficit shall be reduced by the amount of "paid-in capital" (money or tax basis in property) allocable to the shareholder's interest. Although there is no guidance on point, the adjustment is presumably made on an equity class-by-class basis based on the original capital supplied by each class. There is no technical requirement for an adjustment for capital allocable to warrant holders. The theory behind this adjustment is that the paid-in capital of the former shareholders whose interests are terminated or extinguished is not funded by the creditors who become the new shareholders after the company's emergence from bankruptcy. To the extent any such adjustment is required at a subsidiary level (e.g., subsidiary level preferred stock that is canceled), such adjustment should "tier up" to the owning member's interest in the subsidiary under both the current and proposed consolidated return rules. In many cases, this adjustment has the effect of substantially eliminating a corporation's E&P deficit, even though the net operating loss (NOL) carryover and other tax attributes may largely survive in usable form (because of the stock-for-debt exception and/or the special bankruptcy rules of Sec. 382(1)(5) and (6)).

The application of Sec. 312(1)(2) may become substantially more complex for consolidated groups in which not all members are in bankruptcy and/or the current consolidated return rules have not operated to "tier up" the subsidiary's E&P deficits (created, in part, because of "paid-in capital" at the parent level that financed subsidiary operations) because of the add-back for unused NOLs (Regs. Sec. 1.1502-32(b)(1)(ii)). Under the proposed consolidated return rules, however, the subsidiary's deficits would have previously "tiered up" for E&P purposes. Thus, the effect of Sec. 312(1)(2) in the consolidated context will likely become more severe after the proposed consolidated return rules become finalized.

The adjusted current earnings (ACE) provisions require an adjustment for certain amounts (less allowable deductions) excluded from gross income but "taken into account in determining the amount of earnings and profits" (Sec. 56(g)(4)(b)). This provision does not apply, however, to any amount excluded from gross income under Sec. 108 ("Sec. 108 carve-out"). Although any adjustment required by Sec. 312(1)(2) is "taken into account in determining the amount of earnings and profits" within the meaning of Sec. 56(g)(4)(B) (and is no by the Sec. 108 carve-out), the adjustment should not give rise to an ACE adjustment, because it does not affect the determination of current E&P.

Other-stock-for-debt exception

To the extent that the Sec. 108(e)(11)(B) stock-for-debt exception applies and no debt discharge income is realized, the legislative history is clear that no E&P is realized, despite the fact that the corporation has clearly experienced an accretion in wealth (Technical and Miscellaneous Revenue Act of 1988, Senate Committee Report, Act Section 1007). A similar result should occur when subsidiary debt is satisfied with parent stock; under current authorities, the transaction is recast as a subsidiary stock-for-debt exchange followed by a fictional exchange for parent stock (although it is not completely clear that the Service will apply this analysis when the subsidiary is not in bankruptcy and/or the second step of the transaction does not constitute a tax-free reorganization (Rev. Rul. 59-222; IRS Letter Rulings 8933001 and 9105042)). (Note that the stock-for-debt exception was repealed by the Revenue Reconciliation Act of 1993 (RRA) for stock transferred after Dec. 31, 1994, unless the transfer is in a Title 11 case or similar case filed on or before Dec. 31, 1993. E&P will be realized (absent basis reduction under Sec. 1017) after this date.)

Special rule of Sec. 382(1X5)

Sec. 382(1)(5) provides a special rule that, in essence, eliminates what would otherwise be an ownership change under Sec. 382 if the shareholders and "old and cold" creditors of the loss corporation wind up with 50% or more of a company's stock, subject to a "toll charge." The "toll charge" is an NOL adjustment for interest for a specified period prior to the effective date of the bankruptcy plan (interest adjustment) and one-half of what would otherwise be discharge-of-indebtedness income absent the stock-for-debt exception (value adjustment) (Secs. 382(1)(5)(B) and (C)). The interest and value adjustments, however, are only for determining the amount of the NOL that carries over for income tax purposes and do not independently require an E&P adjustment for the amount of the "toll charge." (Note: Given the repeal of the stock-for-debt exception by the RRA, the value adjustment component of the toll charge is generally repealed after Dec. 31, 1994.)