Hidden tax consequences of restructuring debt.

Restructuring debt usually is seen as a means of relieving the debtor's burden. But the process also is plagued with unforeseen income tax problems. Adverse tax consequences can occur when taxpayers in financial distress dispose of business assets or when debt is either written down or completely forgiven.

This month, Daryl V. Burckel, CPA, DBA, professor of accounting, McNeese State University, Lake Charles, Louisiana, and Zoel W. Daughtrey, CPA, PhD, Tenneco Professor of Accounting, Mississippi State University, Starkville, explain how disposition of assets can create unanticipated tax liability in the form of capital gains and discharge of indebtedness income. Since debtors usually don't have the resources to pay the resulting tax, it's important practitioners make clients aware of the tax implications of transferring assets directly to creditors. Proper planning can minimize the tax burden.

When a borrower's obligation to repay a debt is reduced, there may be income tax consequences that depend on the reason for the reduction and the borrower's financial status at the time. In many transactions, debt is reduced because the borrower repaid all or part of it by transferring something of value, such as property, to the lender. If debt is reduced in this way, the borrower is treated as if the lender bought the property for cash and the borrower used the cash to repay the debt. Although repaying the debt yields no income tax consequences, there may be some tax consequences from transferring the property.

If the lender receives no consideration (cash, property, etc.) for all or part of the debt reduction, it is either a gift or a discharge of indebtedness. If a gift, the amount of the reduction is not income to the borrower. If a discharge of indebtedness, the reduction is income, unless

* Payment of the debt would have allowed the borrower to claim a deduction.

* The borrower was in bankruptcy at the time of the reduction.

* The borrower was insolvent at the time of the reduction.

* The discharge was qualified farm indebtedness.

* The debt was between the original buyer and seller under a seller-financed transaction.

INSOLVENCY EXCEPTION

Under the insolvency exception in Internal Revenue Code section 108, discharge of indebtedness income can be excluded from taxable income by an insolvent taxpayer except to the extent he or she becomes solvent as a result of the discharge. Before 1980, several court decisions clearly applied the exception to amounts that exhibit 1, at right, would characterize as gain on sale ineligible for the exclusion.

The most important case was Dallas Transfer and Terminal Warehouse Co. v. Commissioner (70 F.2d 95), in which the taxpayer transferred property to a creditor in satisfaction of a recourse debt. The satisfied debt exceeded the property's value, which in turn exceeded the property's adjusted tax basis. The Fifth Circuit Court of Appeals held no income was to be recognized because the taxpayer was not made solvent by the transaction. This case was cited by Congress when the insolvency exception was certfied in 1980.

The IRS acquiesced in a subsequent Tax Court decision that adopted Dallas Transfer's liberal approach. In 1987, however, the IRS changed its position, narrowing its view of discharge income and the insolvency exception. Now the courts must determine whether the insolvency exception in section 108 is the one described in Dallas Transfer or the IRS's more limited concept.

TRANSFERRING ASSETS

Income tax liability does not result from the transfer of a debtor's assets to a bankruptcy estate. Upon such a transfer, the bankruptcy estate, as property owner, is treated as the debtor would have been if there was no bankruptcy. However, such treatment does not apply if assets are transferred directly to creditors. Generally, transfers to creditors result in gain or loss and in recapture income. Transfers to creditors also may trigger income from the discharge of indebtedness.

In almost every debt workout, some indebtedness is discharged. The circumstances may be a bankruptcy, or the lender simply may write off the debt as part of an arrangement outside bankruptcy. In some cases, if a creditor cannot collect the full amount of the obligation, he or she may be willing to forgive part of the debt if the debtor sells property and uses the proceeds to make partial payment. In other cases, partial payment may be combined with a property transfer to the creditor.

A debtor who uses property sale proceeds as partial payment, as discussed above, and has the remaining debt discharged incurs a tax liability from the gain on sale and from the debt discharge. The sale establishes the property's disposition price and consequently the amount of debt discharged.

To lock in the financial consequences before the actual sale, debtors should secure written agreement that the creditor will forgive any remaining debt after the sale proceeds have been remitted. However, such an agreement will not diminish any adverse income tax consequences.

In Brubeck v. Commissioner (90-1 USTC 50046), the debtors sold equipment with a $3,189 basis at auction for $109,762. The proceeds were applied to a $168,000 lien on the equipment; the remaining debt was not discharged. The debtors were liable for federal and state taxes of $12,300 and $5,300, respectively, on the equipment sale gain. Since the remaining debt was not discharged and Brubeck was still liable, there was no discharge of the indebtedness income.

Had the debt been forgiven, the discharge of the indebtedness income would have been exempt from tax if one of the exceptions listed above applied.

Agreements to transfer property in full satisfaction of an obligation also are treated as if the property had been sold and some debt discharged. One example is deeding land to a security holder in the property. The problem is that no sale has occurred to establish the disposition price or the amount of discharged debt. The following critical question then arises: How much of the forgiven obligation should be considered disposition proceeds (which may create capital gain) and how much discharged indebtedness (which may be excludable)? The answer still is somewhat uncertain for .recourse debt, but it is well established for nonrecourse debt.

RECOURSE DEBT

If the debt is recourse (a debt the borrower is personally liable for), the gain or loss from selling the property is the difference between the collateral's tax basis and its fair market value (FMV). The actual outcome depends on the relationship between the property's FMV and the out-standing debt.

FMV greater than debt. When the transferred property's FMV is equal to or greater than the debt, there is no debt discharge income. The entire obligation is treated as property disposition proceeds, subject to capital gain tax treatment. No debt discharge occurs because the lender received full FMV in satisfaction of the debt. Exhibit 2, below, illustrates this point.

FMV less than debt. When the transferred property has an FMV less than the outstanding debt, the result is both disposition proceeds and debt discharge income, the amounts of which are determined by the property's FMV and the debt amount. The property's FMV is the amount for which the property is conveyed; the debtor is treated as having sold the property for its FMV. Then, the debtor realizes discharge of indebtedness income to the extent the debt exceeds the property's FMV. Exhibit 1 addresses this problem.

NONRECOURSE DEBT

Discharge of nonrecourse debt leads to a much different outcome. Generally, the property's FMV is ignored. The entire difference between the property's tax basis and the full amount of nonrecourse debt principal is treated as gain or loss from sale of the property.

In Tufts v. Commissioner (462 U.S. 300), the U.S. Supreme Court resolved the tax treatment of foreclosure (or deed in lieu of foreclosure) transactions involving nonrecourse debt. Foreclosure is deemed a sale by the borrower to the lender with proceeds equal to the debt. After Tufts, the amount realized with respect to nonrecourse debt must be calculated by reference to the debt's unpaid balance plus accrued interest instead of by reference to the property's FMV.

CHARACTER OF GAIN OR LOSS

Most business assets fit the definition of IRC section 1231 assets. The primary distinction between capital assets and section 1231 assets is the income tax treatment of losses at disposition.

Section 1231 gain. A section 1231 gain can have a significant impact, depending on the taxpayer's status at the time of the transaction. If the taxpayer is insolvent and not in bankruptcy, the section 1231 gain tax liability is a personal liability if the taxpayer is in bankruptcy, any section 1231 gain tax liability remains in the bankruptcy estate. Any tax liability the estate creates but does not pay does not become the taxpayer's personal liability.

Section 1231 loss. In some cases taxpayers may realize a section 1231 loss coupled with discharge of indebtedness income. This can happen when a taxpayer purchases real estate at a high price and later transfers it to a creditor in satisfaction of a debt. Both the cost basis and the debt may exceed the property's FMV. The section 1231 loss can reduce taxable income from other sources, while the discharged debt may be excludable from income. If the FMV of the subdivision in exhibit 1 was $60,000, a $10,000 section 1231 loss could be used to reduce income from other sources. The discharge from indebtedness would be $60,000, which may be excludable under the insolvency exception.

UNEXPECTED TAX CONSEQUENCES

Debtors hoping to gain a fresh start through debt restructuring may find their financial problems have only just begun. Distress transactions can cause unexpected tax consequences. Transferring assets to creditors to satisfy debts may lead to a gain on disposition of the asset and discharge of indebtedness income. While bankruptcy can transfer any tax liability to the bankruptcy estate, careful planning is necessary to maximize tax benefits.

EXECUTIVE SUMMARY

* WHILE THE PURPOSE of restructuring debt usually is to help the debtor, unexpected tax consequences can result if property is transferred directly to a lender to satisfy a loan.

* IF THE LENDER receives no consideration for reducing all or part of a debt, the transaction is either a gift or a discharge of indebtedness. A gift results in no income to the borrower. A discharge of indebtedness is income to the borrower unless certain exceptions apply.

* TO AVOID ADVERSE tax consequences, property should be transferred first to a bankruptcy estate and then to creditors. Direct transfers can result in either gain or loss.

* WHEN RECOURSE DEBT is discharged, the income tax consequences depend on the relationship between the property's fair market value and the outstanding debt.

* THE INSOLVENCY exception allows taxpayers to exclude discharge of indebtedness income if they are insolvent, unless they become solvent because of the discharge.

* IF NONRECOURSE DEBT is discharged, the entire difference between the property's tax basis and the debt principal is gain or loss from the sale of property.

EXHIBIT 1

Discharge income and Internal Revenue Code section 1231 gain from transferred assets

Tom Bolton, a residential developer, obtained a bank loan to develop a subdivision. The loan was secured by a mortgage on the subdivision, and Bolton was unconditionally liable for repayment of the debt. Bolton subsequently became insolvent and defaulted on the loan. To avoid foreclosure proceedings, Bolton entered into an agreement with the bank whereby he voluntarily transferred the subdivision in exchange for a release from all liabilities. Under IRC section 108(d)(3), Bolton was insolvent.

Market value of subdivision at transfer        $100,000
 Bolton's cost basis                              70,000
 Outstanding loan balance                        120,000
 Taxable income from property disposition         30,000
 ($100,000 FMV less $70,000 basis)
 Discharge of indebtedness income                 20,000
 ($120,000 loan less $100,000 FMV)
  Since Bolton is insolvent, the debt discharge income is
excludable.  The gain is not excludable since no
such relief provision exists outside bankruptcy.
  Had Bolton filed formal bankruptcy proceedings, the
gain would have been reported by the bankruptcy estate,
which would have borne any tax liability.

EXHIBIT 2

DISCHARGE OF RECOURSE NOTE: TAXABLE GAIN

Joseph Jones has a $50,000 recourse note secured by a mortgage on some land used in his business. Jones transfers the land, which cost $40,000 and is currently valued at $52,000, to the First National Bank in full satisfaction of the debt. Jones is treated as if he sold the land for $50,000.

There may be an Internal Revenue Code section 1231 taxable gain of $10,000 as well as a return of his cost basis. However, there will be no income from discharge of indebtedness. Thus, none of the gain can be excluded. Note: Section 1231 property includes depreciable or real property used in a business or in the production of income, primarily equipment and machinery, buildings and land.