Tax act repeals stock-for-debt exception.

Buried in the Omnibus Budget Reconciliation Act of 1993 (OBRA) are revenue-raising provisions that repeal the "stock-for-debt exception," which will complicate life for businesses in financial straits. The result could be an acceleration of bankruptcy filings before the year's end.

Generally, when corporate debt is discharged at a discount to its adjusted issue price, the discount amount is included in gross income. If a business is in bankruptcy proceedings or is insolvent, the discount is excluded from income but, under Internal Revenue Code section 108(b), the business must reduce the size of its favorable tax "attributes" (such as net operating losses [NOLs], capital losses, credits and so forth).

For over 50 years, however, a stock-for-debt exception allowed a bankrupt or insolvent business to avoid both gross income and attribute reduction if its debt was discharged for a specified amount of equity. The exception required the stock to be dispersed proportionately among unsecured creditors and to be unavailable when limited-interest preferred stock was transferred to creditors.

The stock-for-debt exception often allowed troubled companies to emerge from bankruptcy with their losses intact although, due to the ownership change that invariably occurred, such losses were limited under section 382.

OBRA repeals the stock-for-debt exception for stock transferred after 1994, although businesses still can claim the exception if the transfer takes place in a bankruptcy case filed before the end of 1993. As a result, bankrupts are likely to find their NOLs largely or entirely absorbed by debt discharge income incurred during the bankruptcy proceeding. Where such NOLs are absorbed but additional debt discharge income remains, OBRA exends the list of tax attributes subject to reduction, which now includes minimum tax credits and passive activity loss and credit carryovers.

Observation: Although the revenue estimates for these provisions total some $1.1 billion from 1994 through 1998, the rules might encourage liquidation of troubled companies rather than rehabilitation and wind up costing the government revenue.