IRS clarifies tax consequences of bankruptcy.

Bankrupt taxpayers generally seek to keep cancellation of indebtedness (COD) income to a minimum so they can emerge from bankruptcy with their net operating losses (NOLs) intact and subject to as few restrictions as possible. The IRS issued final regulations that allow bankrupt taxpayers to avoid COD income by taking advantage of an exception granted to corporations that issue stock for debt. (Although the exception was repealed by recent tax legislation, it remains valid for stock transfers made before 1995.

To satisfy the exception's de minimis requirements, unsecured creditors must emerge with at least 15% of the value of debtors' outstanding stock. Each individual creditor's ratio of stock value received to debt canceled must be at least 50% of the corresponding ratio of unsecured creditors as a group; otherwise, the exception does not apply and the bankrupt taxpayer must declare COD income (which reduces NOL by a corresponding amount) equal to the excess of the debt canceled over the value of the stock issued in exchange for it.

Section 382 of the Internal Revenue Code restricts NOL use through, for example, an annual cap calculated by multiplying the bankrupt company's equity value by the long-term tax-exempt bond rate. A bankrupt company can avoid these restrictions if at least 50% of its stock (both in terms of voting shares and stock value) is transferred to shareholders and qualified creditors (those that have held their claims for at least 18 months before the bankruptcy petition was filed). A loss corporation' may treat debt as always owned by its holder provided the holder is neither a 5% shareholder of the corporation nor an entity through which a 5% shareholder owns an indirect interest in the loss corporation.

Observation: In some cases, a bankrupt taxpayer that meets the 50% rule will choose not to take advantage of the exception and incur the usual NOL limitations instead. Bankrupt taxpayers with carryovers that would be shorted by the restoration of interest deductions and the required add-back of 50% of excluded debt cancellation gain fall into this category.

In such cases, the regulations provide that a loss corporation's equity value is the lesser of the value of its stock immediately after the ownership change or the value of its assets before the change. (For these purposes, stock value excludes stock issued as part of a plan to increase the annual cap without subjecting the investment to the risks of business operations.) The value of stock cannot exceed the value of the property received for its issuance, and the value of the assets before the ownership change cannot include capital contributions made within two years of the change date (except when a contribution is made so the corporation can continue basic operations).

--Robert Willens, CPA, managing director at Lehman Brothers, New York City.