Measuring insolvency for sec. 108 purposes: suggested valuation guidelines.

The convergence of marketplace conditions and changes in the tax law has heightened the importance of the definition of insolvency under Sec. 108(d)(3). Excessive debt undertaken by companies in the heated mergers and acquisitions market of the 1980s, coupled with declining growth, has resulted in a huge increase in debt restructurings. it has become common for companies to partially or entirely retire debt at a discount to its carrying value (or "adjusted issue price")--this can involve a cash repayment, renegotiation of existing debt terms, issuance of new securities or stock, or some combination thereof.

Debt restructurings, both in bankruptcy proceedings and out of court, have become more common. At the same time, tax law changes have largely confined the opportunity to defer or eliminate recognition of cancellation of debt (COD) income outside of bankruptcy to "insolvent" companies and have expanded the occasions on which taxpayers will realize COD income. The Revenue Reconciliation Act of 1990 repealed Sec. 1275(a)(4), which had effectively prevented the realization of COD income in recapitalization debt-for-debt exchanges. Similarly, the Revenue Reconciliation Act of 1993 repealed the Sec. 108(e)(10) stock-for-debt exception, causing taxpayers to realize COD income even more frequently. Troubled companies will now often realize COD income when debt is renegotiated or new securities or stock is issued (in whole or in part) to retire old securities.

Current tax law provides incentives for a company to file for bankruptcy. For example, a corporation in bankruptcy with net operating loss (NOL) or credit carryforwards has more flexibility in mitigating the tax consequences of Secs. 382 and 383 than an insolvent corporation that undergoes an ownership change outside of bankruptcy (or a similar court proceeding). Likewise, G reorganizations are only available to taxpayers in a Title 11 or similar case.

A taxpayer that restructures debt may be encouraged to file for bankruptcy, because all COD income will be excluded under Sec. 108(a)(1)(a). In contrast, under Sec. 108(a)(1)(b) and (a)(3), an insolvent taxpayer that restructures its debt outside of bankruptcy may only exclude COD income to the extent of its insolvency.

This framework nonetheless reflects Congress's intent to provide insolvent taxpayers with limited relief from current taxation of COD income. Depending on the extent of insolvency and magnitude of COD income, the tax relief intended for insolvent taxpayers under Sec. 108 could equal that provided to taxpayers in bankruptcy. Current uncertainty regarding the definition and measurement of insolvency, however, renders the insolvency exception ineffectual and exacerbates the discrepancy between the tax treatments of debt restructurings in and out of bankruptcy.(1)

Companies undergoing debt restructuring are almost always experiencing serious financial and operating difficulties, and are often incapable of funding a sudden tax burden resulting from a debt reduction. If the degree of tax relief is uncertain or unreliable, such businesses are forced to pursue bankruptcy, if possible. In turn, bankruptcy can cause an insolvent company to incur certain costs that it might otherwise avoid, including significant accounting and legal costs. Bankruptcy proceedings can also be cumbersome and time-consuming, thereby exacerbating an already troubled situation. In addition, companies are unfairly disadvantaged by a tax system that favors bankruptcy, because a bankruptcy filing is generally unduly harmful for business or legal reasons.

Many insolvent companies may be able to restructure their debt without incurring the costs and burdens of a bankruptcy filing. However, companies are often reluctant to undertake such a restructuring, because the tax costs are uncertain if the restructuring takes place outside of bankruptcy. This situation is contrary to legislative intent and inconsistent with the policy of tax neutrality in the making of business decisions. This article suggests guidance that should be provided by the IRS to resolve the uncertainty surrounding debt restructuring outside of bankruptcy.

What Is Insolvency?

Generally, Sec. 108(a)(1) provides for the exclusion of COD income if the discharge occurs in a Title 1 1 case or, if the taxpayer is insolvent, to the extent of insolvency. Sec. 108(d)(3) defines "insolvent" as the excess of liabilities over the fair market value (FMV) of assets as determined immediately before the discharge. "FMV" is not defined by the Code. The generally accepted definition of FMV, found in Regs. Sec. 20.2031-1(b), is the price at which property would change hands between a willing buyer and a willing seller, both being adequately informed of the relevant facts, and neither being under any compulsion to buy or sell. The key issue is the appropriate method of determining the FMV of assets and liabilities of an insolvent taxpayer.

* Background

The judicial insolvency exception evolved from a line of cases beginning with Kirby Lumber Co.,(2) in which the Supreme Court held that income was realized when a debt was discharged for less than the full face amount. In Dallas Transfer Terminal Warehouse Co.,(3) the Fifth Circuit held that no income was realized from the discharge of debt when the debtor was insolvent both before and after the discharge. Income was not realized because no assets were freed from the claims of creditors. The "freeing up of assets" approach remains relevant today, as the legislative history of the Bankruptcy Tax Act of 1980 (BTA) states that the BTA is a codification of the judicially developed insolvency exception.(4) The legislative history of the BTA indicates that Congress intended to follow the Bankruptcy Code in determining a taxpayer's insolvency.(5)

The definition of insolvency under Sec. 108(d)(3) is similar to the definition under the Bankruptcy Code. Bankruptcy Code Section 101(32)(A)(6) defines "insolvent" as a "financial condition such that the sum of such entity's debts is greater than all of such entity's property, at a fair valuation. . . ." The similarity in definitions appears to be further evidence of Congress's desire to integrate bankruptcy and tax law.

Approaches to Insolvency Valuation

Neither Sec. 108 nor the BTA committee reports specify the valuation approach that should be undertaken to determine insolvency under Sec. 108. Most commentators believe that the proper valuation approach for this purpose is a "going concern" approach, as opposed to using liquidation values. To determine going concern value, the prevailing view appears to be that the FMV of the debtor's assets should include tangible assets, as well as goodwill and other intangible assets (e.g., patents and trademarks).(7) However, some commentators advocate the use of a valuation approach that essentially measures the replacement value of only hard assets.(8) The problem with the replacement value approach to insolvency valuation is that it values the individual assets and liabilities of a business, rather than the whole business as an ongoing enterprise. With respect to a viable business that is not contemplating liquidation, a replacement approach is not economically realistic. Further, since going concern valuation approaches need not separately value individual assets, the question of certainty in handling intangibles becomes moot.

Under bankruptcy case law, "[t]he valuation of the debtor's business and assets can be based on a number of appraisal approaches that have been widely accepted by bankruptcy courts, including replacement value, net asset value, liquidation value, going concern value, comparable corporation value, capitalization of earnings and discounted future earnings."(9) The appraisal approach accepted by a bankruptcy court may vary from court to court depending on the type of case, the facts and the proposed use or contemplated sale of the assets or business.(10)

For example, in a chapter 7 liquidation, a liquidation approach is used to value the debtor's assets. In contrast, a going concern approach is used in chapter 11 bankruptcy reorganizations when the business will continue in some form.(11) The most logical method to value an asset for Sec. 108 purposes is to adopt a valuation approach that will take into consideration the likely use of the insolvent taxpayer's assets (as contemplated under the bankruptcy law), while at the same time complying with the Sec. 108(d)(3) definition of insolvency.

An asset or liability can be individually valued only by using a liquidation or replacement value approach. If a liquidation approach is used, only tangible assets, identifiable intangible assets and liabilities that exist on the date immediately before the COD can be identified and valued for purposes of determining the taxpayer's insolvency. Other intangible assets (e.g., goodwill and going concern value) are not severable from an ongoing operation and must be left out of the insolvency equation; essentially, they measure expected future income in excess of a reasonable rate of return on the investment in tangible assets. The liquidation approach to valuation, by definition, assumes that the assets will produce no future value for the taxpayer and that the taxpayer's operations will immediately cease, thereby also eliminating the possibility of the company incurring future liabilities. This approach is logical only to the extent the business actually will be liquidated.

If the business will continue to operate, as is the case in the vast majority of potential out-of-court debt workout situations, a replacement or liquidation approach does not reflect the true value of all assets. Significant intangible assets and other corporate attributes would be excluded from the valuation. Banks and other lenders often continue to finance against intangible assets and cash flow; therefore, these values should be recognized for an ongoing business. As the ratio of intangible to tangible assets increases for a business, it becomes increasingly distortive to exclude intangibles in measuring insolvency. Such a formulation could cause a significant number of businesses, conceivably certain entire industries (e.g., software development), to be mathematically insolvent.

An additional problem with a liquidation or replacement value approach is that individually identifying and valuing each asset and liability raises formalistic questions regarding which assets and liabilities are "definite" enough to be included in the calculation. Many assets and liabilities included in a company's financial statements are not typically viewed as assets and liabilities from a tax perspective, because they are estimated rather than actual), uncertain or otherwise contingent. Environmental liabilities, future employee benefit liabilities, expected severance and restructuring costs and similar liabilities would each have to be examined to determine whether or not they are fixed, contingent or not liabilities at all. If liquidation of the business is .not expected, such an exercise focuses unduly on accounting, tax and legal concepts instead of on true economic value.

An example of the existing confusion and uncertainty can be found in an attempt by the Service to articulate a position on which liabilities are to be included in determining insolvency. In Letter Ruling (TAM) 8348001,(12) in determining COD income for an insolvent deceden't's estate, the Service, citing Conestoga Transportation Co.,(13) stated that there is no authority for considering contingent or contested liabilities for purposes of determining insolvency. However, in Conestoga, the Tax Court allowed reserves for wages and injury and damage claims in measuring insolvency, without discussing the contingent nature of those reserves; moreover, the Service acquiesced in Conestoga.

In support of its statement in TAM 8348001 that contingent or contested liabilities should be excluded from the insolvency determination, the Service cited Consolidated Edison Co.,(14) which involved the timing of a company's income tax deduction for accrued real estate taxes. The inference is that only liabilities that can be accrued for tax purposes should be considered in measuring insolvency, an approach that would have economically dubious results under the current Code. For example, liabilities that could not withstand the severe restrictions imposed by the economic performance requirement of Sec. 461 (h) would not be considered in determining insolvency. The exclusion of liabilities that may not be accrued for tax purposes would frequently prove inconsistent with the "freeing up of assets" principle that forms the underlying basis for the insolvency exception. Accordingly, taxpayers should be able to look elsewhere for guidance in determining insolvency.

Bankruptcy law generally does not help to determine whether a liability should be included in an insolvency determination because, in a bankruptcy proceeding, liabilities are generally determined by creditors' claims filed with the court. While certain liabilities, such as warranty claims or product liability claims, may be considered, their consideration generally is reflected as a reserve resulting in a reduced asset value, rather than as a creditor claim against the bankrupt estate.

Alternatively, taxpayers might look to other areas of tax law in which the determination of liabilities or use of the term "insolvent" is relevant. However, other areas of tax law are not necessarily predicated on policy analogous to the "freeing up of assets" principle. Accordingly, their application could distort the purpose of the Sec. 108 insolvency exception.

* DCF method

A more appropriate valuation approach to determine the insolvency of a business in the usual Sec. 108 context would be to apply a discounted cash flow (DCF) methodology complemented by a public market comparable (PMC) analysis. The DCF technique is used to value a business on a going concern basis. It is widely used in the analysis of capital stock, acquisition candidates and capital projects. indeed, banks and other creditors participating in a debt workout will typically perform a DCF analysis, which measures intrinsic value by assessing the present value of future cash flows derived from assets or business operations. When applied to a business, the resultant value captures all of the value attributable to the entire business, without specifically ascribing value to the individual underlying assets and liabilities. Therefore, interpretive issues pertaining to the effect of specific items, such as debt obligations that were issued at a discount, "contingent" liabilities and tax NOLs, are minimized by use of the DCF technique. Although the use and application of a DCF valuation approach might appear subjective, this approach is based on very well-established valuation principles and is often used in connection with tax planning. Courts in recent years have accepted more sophisticated valuation techniques for tax purposes, such as DCF.(15)

The PMC analysis is based on the assumption that comparable publicly traded companies having similar business attributes can be valued by examining various ratios that measure certain key financial characteristics. The ratios express the value of the subject company as a multiple of the key financial performance characteristics. In general, comparability can be defined somewhat loosely, if necessary, while still providing a useful benchmark range of values. In the Sec. 108 context, the appropriate financial characteristics would reflect ratios related to the total capital value of the business and the earnings before interest expense and taxes. The resultant values obtained by this approach would then be used to validate the figures derived from application of the DCF methodology.

It should be acknowledged that a publicly traded company can be insolvent as defined in Sec. 108(d)(3), yet still have stock trading; in such instances, stockholders are essentially invested in options. While the current value of the business may be less than its liabilities, speculative stock-holders are willing to pay something (albeit a small amount) for the opportunity to participate in the future of the company. In effect, the investor is relying on the expectation that the company will be able to negotiate and manage its way out of the dilemma.(16)

Key factors that can vary in applying the DCF technique are the discount rates and terminal value calculations. To determine the equity value of a business, an equity discount rate is applied, usually determined by using the Capital Asset Pricing Model to discount the company's future cash flows. in determining the total enterprise value of a business, a weighted average cost of capital (WACC) is used, reflecting a return to both the equity and debt holders. Under the WACC method, a valuation expert values the entire business by calculating the present value of expected future cash flow, excluding only return of equity payments and payments relating to funding sources that pay interest (i.e., interest-bearing debt). All other liabilities (including contingent liabilities, accounting reserves, inter-company payables, etc.) are estimated and treated as expenses of the business requiring payouts that reduce future cash flow. The valuation of the business would be based on a discounted cash flow of all future revenue and expenses as determined and estimated by a professional appraiser.

A modification of the weighted average cost of capital (MWACC) technique to value the taxpayer's assets and liabilities would perhaps most literally comply with the definition of insolvency under Sec. 108(d)(3). Under an MWACC approach, all payments relating to items considered liabilities for tax purposes are removed from the cash flow model at their net present value (as estimated by a professional appraiser) and are deemed to be liabilities similar to interest-bearing debt in the WACC approach. Using this technique, the value of the assets increases as these estimated liabilities are removed from the cash flow model; however, the value of a business net of all liabilities should remain the same under both the WACC and the MWACC approaches. The MWACC approach may more literally conform to the Sec. 108(d)(3) definition of insolvency, valuing the assets of the business separately from respective liabilities at the time of COD. The values of these liabilities are also determined by the appraiser in the initial WACC model. As an appraiser's estimate of these liabilities is generally accepted by the business world in determining the value of a business for many other purposes, it seems appropriate that the Service should also accept an appraiser's estimates of liabilities for the purpose of determining insolvency. This approach leaves the determination of which assets and liabilities are to be included in the valuation in the province of the appraiser rather than the tax adviser. Given the purpose and context of Sec. 108 insolvency, this is both an appropriate and enlightened result.

Use of DCF in Other Tax Contexts

The Service permits (and often encourages) professional valuations using DCF and other present value techniques in a variety of contexts. The use of valuation techniques is well established in the area of estate and gift taxation.(17) In particular, Regs. Sec. 20.2031-2(f) discusses the use of a going concern valuation approach in valuing the stock of a closely held business. As mentioned earlier, DCF is gaining increased acceptance in the courts.(18) Rev. Rul. 59-60(19) and Regs. Sec. 20.2031-2(f) list numerous factors that a valuation expert may take into account when valuing an entire operating business, the same factors that would be taken into account to value a business under the proposed MWACC valuation method. In fact, Rev. Rul. 59-60 discusses the proper use of capitalization rates in determining fundamental valuation factors. In addition, the present value method is used as a secondary valuation method to determine the FMV of mineral property under Regs. Sec. 1.611-2(d) and (e). Thus, the valuation of a business using DCF has strong precedent in tax law and administration.

Professional valuations are also encouraged and accepted in the planning and design of incentive stock options (ISOs). Prop. Regs. Sec. 1.422A(2)(e)(2)(ii) provides a safe harbor for determining whether a good-faith attempt was made to set the option price for ISOs on nonpublicly traded stock at not less than the FMV of the stock subject to the option at the time the option was granted. A taxpayer may qualify for the safe harbor by setting the option price at the average of the FMVs determined by independent and well-qualified experts. An independent appraisal may also provide a taxpayer a safe harbor in determining the value of charitable contributions of property (Regs. Sec. 1.170A-13(c)(31); casualty losses (Regs. Sec. 1.165-7); property contributed to a settlement fund (Regs. Sec. 1.468B-3(b)); and securities in an employee stock ownership plan (Sec. 401(a)(28)(c)).

A similar safe harbor rule should be adopted to ensure a fair and reliable determination of insolvency under Sec. 108--i.e., the Service should accept the average insolvency valuation of two well-qualified valuation experts as a fair determination of the extent of the taxpayer's insolvency. This approach would ensure the Service of a fair valuation of the taxpayer's insolvency while allowing the taxpayer to rely on the Sec. 108 insolvency exception with the certainty needed to effectuate a successful out-of-court debt restructuring.

Finally, the Service can take comfort that a safe harbor approach presents little opportunity for taxpayer abuse, given the numerous constraints that inhibit a taxpayer's ability and desire to exaggerate insolvency. These factors(20) include:

[] Insolvent companies are precluded by the laws of most (if not all) states from declaring dividends.

[] Once insolvency is declared, present and certain past transactions become subject to challenge under the rules pertaining to fraudulent conveyances.

[] Most (if not all) indentures and loan agreements provide for debt maturity acceleration in the event of a declared insolvency.

[] A debtor's financial statements may be adversely affected by declaring insolvency. A debtor may have to write down the value of its assets, and the debtor's independent auditor may issue a qualified opinion due to substantial doubt about the company's ability to continue as a going concern. Such disclosures typically make trade creditors less willing to deal with the debtor, can eliminate any remaining access that the debtor may have to the capital markets and potentially cause severe problems with regulatory authorities.

[] Obtaining any insolvency appraisal may encourage creditors to file an involuntary bankruptcy petition with respect to the debtor f or fear that future debt payments will be treated as preferential.

[] Obtaining an insolvency appraisal may heighten the fiduciary obligations to which the debtor's board of directors is subject.

Conclusion

By enacting the insolvency exception to COD income, Congress intended to offer insolvent taxpayers relief from the immediate adverse tax implications of canceling debt. However, the relief intended by Congress is effectively unavailable due to the absence of guidance by the Service in defining insolvency. This absence influences many taxpayers to declare bankruptcy rather than face the uncertain tax consequences of the insolvency exception. Indeed, "prepackage" tax-influenced bankruptcy filings have become all too common. Thus, the Service should issue guidance (in the form of regulations or a revenue procedure) to ensure that the intended legislative relief under Sec. 108 is available to insolvent taxpayers. The Service should allow taxpayers to measure insolvency by averaging two valuations performed by well-qualified professional appraisers. These independent appraisals should measure insolvency using a going concern approach, such as DCF complemented by a PMC analysis.

Such an approach to measuring insolvency is the economically appropriate model to value an ongoing operating business. In addition, it will avoid a debate between the Service and tax practitioners over which assets and liabilities are properly included in an insolvency valuation. Effectively, those decisions will be determined by valuation experts just as they are for virtually all other business or investment purposes. The use of a safe harbor approach to insolvency valuations would help ensure a fair valuation of the taxpayer's business while properly affording the benefits intended by the Sec. 108 insolvency exception.

(1) See Sherck, "Restructuring Today's Financially Troubled Corporation," 68 Taxes 881, 885 (Dec. 1990); see also Sheppard, "Congress Tries to Work Out the Workout Rules," 56 Tax Notes 696, 698 (8/10/92) (". . . the alternative [to a bankruptcy filing], proving insolvency, is so time-consuming and expensive that no one bothers with it."). See also Henderson and Goldring, Failing and Failed Businesses: Tax Aspects of Bankruptcy Restructurings of Troubled Corporations, p. 71 (Little, Brown & Co., 1995) "The great practical advantage to the taxpayer in bankruptcy is that there is no need to prove insolvency. . . .").

(2) Kirby Lumber Co., 284US 1 (1931) (10 AFTR 458, 2 USTC [paragraph] 814). (3) Dallas Transfer & Terminal Warehouse Co., 70 F2d 95 (5th Cir. 1934)(13 AFTR 930, 4 USTC [paragraph] 12 70). (4) See Written Comments on Certain Aspects of H.R. 5043, Subcommittee of Select Revenue Measures, House Ways and Means Committee (2/20/80). (5) See Review of H.R. 5043, Subcommittee of Select Revenue Measures, House Ways and Means Committee (2/20/80) (in conformity with the bankruptcy Reform Act of 1978, tax attribute reduction is extended in H.R. 5043 to cover insolvent taxpayers who benefit from the exclusion of COD income); Rep. Ullman's Statement Regarding Bankruptcy Tax Legislation, Congressional Record -- House, at 34106. (Stating that the development of tax rules for bankruptcy and insolvency neither reflects pure tax theory nor completely subordinates tax principles of conflicting bankruptcy concerns; however, the COD rules for a bankrupt or insolvent debtor were recommended by the Commission on Bankruptcy Law and endorsed by the 95th Congress House Judiciary Committee. (6) 111 USC Section 101(32)(A). (7) See McQueen and Crestol, Federal Tax Aspects of Bankruptcy, [sections] 2.07 (McGraw-Hill, Inc., 1984); Newton and Bloom, Bankruptcy and Insolvency Taxation, [sections]4.8 (John Wiley & Sons, Inc., 1991 Supp.). (8) See Witt and Lyons, "An Examination of the Tax Consequences of Discharge of Indebtedness," 10 Virginia Tax Review 1, 54, n. 237 (Summer 1990) (arguing that goodwill and other intangible assets should be excluded because their value cannot be determined with sufficient certainty). (9) See Pollard & Burton, Guide To Effective Bankruptcy Litigation, [sections]17.08 (McGraw-Hill, 1991). (10) See In re Fiberglass Industries, Inc., 74 B.R. 738, 741 (1987.). (11) See Fortgang and Mayer, "Valuation in Bankruptcy," 32 UCLA Law Review 1061, 1063 (1985). (12) IRS Letter Ruling (TAM) 8348001 (no date given). (13) Conestoga Transportation Co., 17 TC 506 (1951), acq. 1952-1 CB 2. (14) Consolidated Edison Co. of N.Y., Inc., 366 US 380 (19611(7 AFTR2D 1451, 61-1 USTC [paragraph] 9462). (15) See, e.g., The Northern Trust Co., Transferee and Trustee, 87 TC 349, 3 78-381 (1986). (16) See, e.g., "Stock Is Worthless, But It Finds Buyers On a Top Exchange," The New York Times (3/18/92), p. 1. (17) See, generally, Regs. Sec. 20.2031; Rev. Rul. 59-60, 1959-1 CB 237, amplified by Rev. Ruls. 77-287, 1977-2 CB 319; 80-213, 1980-2 CB 101; and 83-120, 1983-2 CB 170. (18) See, e.g., Northern Trust, note 15. (19) Rev. Rul. 59-60, note 17. (20) SOMC of these factors were discussed in the Report to the House of Delegates, American Bar Association, Section of Taxation, August 1993.

Authors' note: The authors gratefully acknowledge the research assistance of Steven B. Katz and Lawrence S. Van Blerkom, and the helpful comments of Mary Ellen Bresciani, Robert B. Haran, Dennis J. Lubozynski, Thomas E. Mischell, Robert M. Rosen and Brian E. Rowe.

Editor's note: Mr. Abahoonie is the chairman of the AICPA Tax Division Corporations and Shareholders Taxation Committee.