Stock-for-debt swaps: Net operating losses still available to facilitate chapter 11 reorganization
Takasumi, Laura L
Under the Taxpayer Relief Act of 1997, net operating losses can now be carried forward for up to 20 years after the date of the loss (it used to be 15 years) and carried back only 2 years (it used to be 3 years). Since 1986, the Internal Revenue Service has made it very difficult for a corporation to use old net operating losses when the ownership of the corporation changed hands. This so called “trafficking in net operating losses” was effectively stopped by changes to Section 3821.
Under certain circumstances a corporation can continue to use these old net operating losses. This opportunity exists where, a bankrupt corporation (“Deadbeatco”) has unsecured creditors who exchange their debt for stock. This “bankruptcy exception” can be an attractive alternative in the right circumstances. Because a bankrupt corporation almost always will have significant net operating losses, the use of this exception can allow the reorganized Deadbeatco to offset income taxes for many years. Creditors who otherwise might not be paid can receive equity in a business with potential growth, benefit from projected income (without the burden of income taxes) and perhaps receive repayment in that manner.
Overview Of Section 382
Section 382 applies when there has been an ownership change. Generally, an “ownership change” occurs when 50% or more of the stock has changed hands. An ownership change can also occur where there has been a merger or similar tax-free reorganization. If an ownership change has occurred, only a portion of a pre-ownership change net operating loss can be offset by post-ownership change income. This limit is equal to the value of the stock of Deadbeatco immediately before an ownership change multiplied by the long-term taxexempt rate. The long-term tax-exempt rate is currently 5.27% and is set each month by the IRS.
There is an exception to these rules for bankrupt corporations under Section 382(1)(5). This exception would apply if a stock-for-debt exchange was approved by a court when: (1) Deadbeatco was under the jurisdiction of a bankruptcy court in a Title 11 or similar case (i.e., receivership, foreclosure or similar proceeding in federal or state court) immediately before an ownership change; and
(2) the shareholders and creditors of Deadbeatco own fifty percent of the value and voting power of Deadbeatco’s stock immediately after an ownership change (the “continuity of ownership” test).
Only stock received by “qualified creditors” is counted to determine whether the fiftypercent continuity of ownership test is met. To be a qualified creditor, the indebtedness exchanged for the stock:
(1) must have been held by the creditor at least eighteen months prior to the date of filing of the Title 11 or similar case (most applicable to long-term debt); or
(2) must have arisen in the ordinary course of the trade or business of Deadbeatco and must at all times have been held by Deadbeatco (most applicable to trade creditors).
Only stock that is received by creditors in partial or full satisfaction of the prior indebtedness is counted to determine whether the continuity of ownership test is met. Stock received by shareholders or qualified creditors in return for new capital contributions is not included.
Special Rules Applicable to Bankruptcy Even if a stock-for-debt swap qualifies under Section 382(1)(5), there are several provisions that reduce the amount of pre-change NOL carryforwards that are available to Deadbeatco.
Reduction in Carryforwards for Interest Payments to Qualified Creditors Deadbeatco’s NOL carryforwards are reduced by the amount of interest paid or accrued on the indebtedness that was converted into stock during the period beginning on the first day of the third taxable year preceding the taxable year in which an ownership change occurred and ending on the date of the ownership change.
Reduction for Cancellation of Indebtedness Income
In general, income includes income from the cancellation of indebtedness (“COD”). If a corporation distributes property with a value less than the face value of the discharged claims, the corporation must recognize income from the COD. However, there is an exception to this rule permitting non-recognition of such income if the COD occurs in a Title 11 case or where the corporation is insolvent. The price paid for this nonrecognition is the reduction of NOL carryforwards by the full amount of the COD income.
Prohibition Against Second Ownership Change within two years If a second ownership change occurs in the two-year period following an ownership change, the special bankruptcy rules would not apply and the NOLs that arose before the first ownership change would be completely eliminated.
Tax Effect on Creditors Generally, a creditor will receive stock with a lower value than the debt for which it was exchanged, and will therefore recognize a loss. However, if the reorganization qualifies as a so-called “G” reorganization this might not be the case.
A “G” reorganization is a transfer by Deadbeatco of all or substantially all of its assets to another corporation in a Title 11 or similar case wherein the consideration received by Deadbeatco is distributed pursuant to the plan of reorganization. Whether or not a creditor will recognize income or loss as a result of the “G” reorganization depends upon the nature of the debt instrument exchanged and the value assigned the stock received in the exchange. Generally short-term debt is not a security and long-term debt is a security. Although the case law is unsettled, notes that are for less than 5 years are probably not securities.
Short-term Creditors (Less than 5 Years)
Creditors who exchange a debt instrument that is not recognized as a security for federal income tax purposes will recognize gain or loss on the exchange of their indebtedness in return for stock in Deadbeatco. Almost all trade creditors will, therefore, recognize gain or loss.
Long-term Creditors (More than 5 Years) Creditors who hold securities will normally receive non-recognition treatment in their exchange of securities for stock in the acquiring corporation. However, gain will be recognized if the security holder receives securities with a principal amount greater than the principal amount of the securities that were surrendered. In addition, a creditor will recognize interest income to the extent the creditor receives new stock attributable to accrued but unpaid interest.
NOLs still can remain a valuable attribute of a Chapter 11 reorganized corporation if the creditors swap their debt for stock and comply with the complex rules of Section 382(I)(5).
‘ Internal Revenue Code of 1986, as amended (“Section”)
Laura L. Takasumi and Aaron Jay Besen are tax lawyers in the Business Practice Group of Sussman, Shank Wapnick, Caplan & Stiles LLP, in Portland, Oregon. The firm’s 37-year history started in Bankruptcy and Creditor’s Rights which remain a significant practice group in the firm. The firm has represented Bank of America and several other banks and lenders in large Chapter 11 cases including Melridge Global Floral, and Smith’s Home Furnishings. The firm has also been debtor counsel in numerous Chapter 11 reorganizations in the Pacific Northwest and elsewhere including Plaid Pantry Markets and Beaver Coach. The firm has also represented creditors’ committees in significant cases such as Floating Point Systems and Columbia Western, Inc.
Copyright Credit Research Foundation First Quarter 1998
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