By: Kyle Propsner, CPA, and Nastassja Markham Coletta, JD, LLM
Are you a business owner exploring new borrowings or the restructuring of current debt as a pathway to satisfy cash needs? Current economic conditions may present an opportunity to secure new borrowings at a discount or modify current debt with relaxed covenants, yields, terms, or rates. To avoid unforeseen tax consequences while restructuring debt, you should understand the various ways a debt instrument can be modified and the potential tax implications.
Lenders providing relief in the form of debt modifications to help alleviate cash burn during economic downturns is quite common and actually advantageous for both parties as it may be essential to the servicing of the debt. On the surface, it may appear any relief would be favorable. However, you should be forewarned that certain relief may come with unforeseen tax consequences.
How Modifications to Debt Instruments May Trigger Cancellation of Debt Taxable Income
You may unknowingly trigger cancellation of debt (“COD”) income when you modify the terms of your debt. COD income is created when debt is cancelled, reduced, or discharged. COD income is basically phantom income – you never see the dollars, but you are taxed as if cash was received as income and then used to pay off the debt. COD taxable income is recognized in the tax year a significant debt modification occurs, which may be a bit of salt in the wound for those already under financial duress or pressure. For example, COD income may increase your tax liability while also decreasing a net operating loss that could otherwise be carried back to a higher income year and provide cash relief. To prevent an unintended tax consequence, like COD income, you should understand how a “significant modification” to a debt instrument is determined.
Types of Significant Modifications
General rule – Modifications to a debt instrument are considered significant if, after considering all facts and circumstances, they collectively result in economically significant changes to the legal rights or debt obligations of the debt instrument. This test is only applicable if another significant modification test does not apply.
Change in yield or reduction in principal – For certain debt instruments, a change in yield by more than the greater of either ¼ of one percent (25 basis points) or 5% of the debt instrument’s annual yield is considered a significant modification. Additionally, a reduction in principal is subject to the same “change in yield” test because it effectively lowers required repayments and, therefore, results in a reduced yield.
Change in timing of payments – A change in the timing of payments that results in a material deferral of payments is a significant modification. Whether a deferral is “material” depends on the facts and circumstances. A safe harbor currently exists for deferred payments if they are unconditionally payable within the lesser of five years or half the original term of the debt instrument.
Change in obligor – A change in the obligor on a recourse debt instrument is generally a significant modification, although certain exceptions exist, while a change in the obligor on a nonrecourse debt instrument is not. The addition or removal of a co-obligor on a debt instrument may also be considered a significant modification.
Change in security – A modification that alters the collateral, guarantee, or other credit enhancement for a debt instrument is generally considered a significant modification, although some exceptions exist for nonrecourse debt instruments. In addition, a change in the priority of a debt instrument relative to the issuer’s other debt is a significant modification if it results in a change to the payment expectations, which is defined as either the substantial enhancement or impairment of an obligor’s ability to meet the payment obligations.
Change in the nature of a debt instrument – Generally, a change in the nature of a debt instrument from primarily recourse to primarily nonrecourse, or vice versa, is considered a significant modification, although exceptions exist for certain circumstances.
Change to accounting or financial covenants – Modifications to a debt instrument that alter customary accounting or financial covenants are not significant modifications. However, if the debtor makes a payment to the lender as consideration for the modification, the payment is subject to the “change in yield” test and could result in a significant modification.
Further Tax Planning Considerations Related to Debt
So, what can be done? If you are considering restructuring your debt, contact your trusted tax advisor before anything is finalized – the earlier an advisor is brought in the more impact they can have. If you have already finalized your debt restructuring, a tax advisor may provide planning ideas to reduce the financial impact of COD income. Year end is quickly approaching – contact your tax advisor as soon as possible to ensure there is ample time for proper planning.
The Tax Warriors® at Drucker & Scaccetti are here to help you evaluate the tax consequences of certain business decisions and properly understand how the tax laws effect your bottom line. And, if this article was helpful, see these other reads related to liquidity and restructuring: