Tough Times for Lenders : Financial Services Lawyer & Attorney : Winstead Law Firm : Finance, Banking, Bankruptcy

While the nature of the collateral securing a loan may change, while the local market may change, while the number and nature of the lenders in the credit stack may change, while "X" (you fill in the  "X") may change, ONE thing never changes . . . . 

. . . income taxes.

And I suspect that the impact of debt restructures (and foreclosures) on income taxes will become more and more important in the future.  But let's not overlook the importance of this topic today.

In prior postings, we've touched on the importance of income tax issues, including cancellation of debt income and other "bad" consequences [2nd of two postings].

Below is a list furnished by a partner of mine, Julie Sassenrath.  Julie has in-depth knowledge of the tax code, case law and IRS rulings, and has a very, very practical bent.  She uses variations of this list as a starting point to assess the tax consequences of a specific workout or foreclosure.

Collecting this information often is a key element in any debt restructuring plan, whether you are the key principal behind the borrower, or the asset manager pursuing the recovery of the Lender's investment.

Here is Julie's quick list:

• Amount of debt (principal and accrued but unpaid interest)
• Has accrued but unpaid interest been deducted?
• Recourse v. non-recourse nature of the debt
• Guarantors or other persons liable for debt (and relationship to partners), and nature of liability
• Basis of the property (collateral)
• Basis of partnership interests of the partners
• How has the debt been allocated among the partners for tax/basis purposes?
• Identity of the partners (and their partners if a partnership) and ownership interests
• Financial status of each partner (solvent, insolvent, bankrupt, etc.)
• Tax attributes of each partner (NOLs, passive losses, capital losses, etc.) and overall tax picture of each partner
• Other real estate interests held by each partner
• Other assets held by the partnership
• Fair market value of the property (collateral)

If and when you focus on income taxes in a plan, be sure to contact an experienced adviser.

Frankly, I am NOT familiar with this topic.  When faced with this topic, I quickly reach out to Julie or another tax lawyer at my law firm for help.

If you have information or questions to add to this list, please post a comment below.

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Periodically, we post commentary on this important topic.  Frankly, it can literally drive the structure of a workout, and most certainly the timing of it.

And as painful as this is to admit (because I've really started to like writing on ToughTimes), reading this text might be a little "dry" or even tiresome (although I do try to spice this up—but within the boundaries of the "law firm thing").

As a change of pace, Mike Cook , who authored several pieces previously posted, will host a webinar on this topic.  The information is below, and I have attached the "official" invitation.  So, if you like a more formal approach, download the invite (PDF).

Please freely forward this blog entry or "official" invitation to anyone interested in this topic.

Note that unlike this blog, the webinar is NOT free.  However, the $12\screen charge is the cost charged to us by the 3rd party service provider—there is no profit in it for us.

If you have other topics that you think will merit a webinar, please post a comment. 

Federal Tax Treatment of Debt Workouts

When: Wednesday, September 16, 2009 at 10:00 a.m. - 11:00 a.m. CST
Speaker: Michael L. Cook, Winstead PC

Description: This webinar will highlight certain federal income tax consequences to debtors and lenders in the context of debt workouts (including cancellation of debt (COD)income, exceptions to COD income, and the tax consequences of foreclosures and deeds in lieu of foreclosure), including the 2009 legislative changes allowing an election defer COD income.

Who Should Attend: 
Accounting professionals, tax professionals, in-house legal counsel and consultants

Register by September 14 at:
http://www.winstead.com/CEWebinarSeries

$12.00 registration fee per computer screen
Payable via major credit card

Webinar instructions will be sent upon registration
**  Participants must have a Java-enabled browser  **

Continuing Education Credit Information
Texas Bar CLE: 1 credit hour
CPE: 1 credit hour

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Guest Writer - Mike Cook, Winstead PC

2nd in a series of 2 postings
(Part 1: The Insolvency Exclusion to Cancellation of Debt (COD) Income;
The Effect of Exempt Assets Under the Carlson Rule)

The Court, having determined that the use of “assets” was ambiguous, pointed out that “[t]he stated purpose of the 1980 Bankruptcy Tax Act was to ‘accommodate bankruptcy policy and tax policy.’” Both Senate and House reports indicate that the proposed insolvency exception in Section 108(a)(1)(B) was intended to ensure that an insolvent debtor outside of bankruptcy (like a debtor coming out of bankruptcy who is accorded a ‘fresh start’ under Federal bankruptcy laws) is not to be burdened with an immediate tax liability.

The Tax Court, however, concluded that although an asset of a debtor may be exempt from the claims of creditors under applicable law, if that asset and the debtor’s other assets exceed the debtor’s liabilities, the debtor has the ability to pay an immediate tax on income from discharged indebtedness. By implication, therefore, the same Congress that decided that it was in the public interest that exempt assets be removed from the reach of creditors so that debtors could obtain a fresh start intended, nevertheless, to impose an income tax on the value of those assets in the event that a taxpayer negotiated a debt settlement with creditors outside of bankruptcy. In effect, the Carlson Court concluded that Congress intended to impose a penalty on taxpayers that handled their financial problems without resorting to the bankruptcy court.

Under the Carlson rule, an individual with substantial exempt assets pays a high penalty for not filing bankruptcy. The opposite viewpoint, however, is that the reason the Tax Court has sided with the government is because the cases from the late 1980s showed the gross disparity in tax treatment that could occur from the differences in exempt assets allowed from state to state. In Texas, a person with substantial exempt assets could successfully take an insolvency position under the old law. It should be noted that only the Tax Court has addressed the issue, and if the economic conditions currently being experienced produce the same quantity of workouts from commercial debt (COD from residential loans is currently excluded from gross income) as occurred in the 1980s, the issue of whether exempt assets should be excluded from the insolvency calculation will surely reach several courts of appeal.
 

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Guest Writer - Mike Cook, Winstead PC

Part 1 of 2

During the current economic crisis, debtors will be negotiating workouts with lenders and if the debtors successfully obtain debt relief, they will also be seeking tax relief from the taxation of COD income. The ability to use the broadest exclusion from COD income, the insolvency exclusion, has been severely restricted in recent years. The relief from taxation of COD income by reason of insolvency of a taxpayer has a common law history, but it was codified in 1980 as Section 108(a)(1)(B) of the Internal Revenue Code. The legislative history of the Bankruptcy Tax Act of 1980 made it clear that a purpose of the statutory insolvency exclusion was to put insolvent taxpayers on the same footing as those who filed bankruptcy, which also excludes COD income from taxation. But recently the Tax Court has penalized taxpayers for not filing bankruptcy; the insolvency exclusion does not now produce the same tax results as does bankruptcy. So are debtors better off filing bankruptcy than entering into a debt settlement with lenders?

When an individual files bankruptcy and is relieved of personal liability, the debtor comes out of bankruptcy with his/her exempt assets and there is no taxation of the relief of liability because COD is not income pursuant to Section 108(a)(1)(A). In the late 1980s, when the banking and real estate industries collapsed in the southwest United States, taxpayers relied on old case law to the effect that their exempt assets were not included in the insolvency calculation. The IRS seemed to back away from its initial litigating position and agreed with the taxpayers’ exempt asset position, but in the 1990s the IRS put taxpayers on notice that its position was that the insolvency calculation should be calculated without inclusion of the exempt assets. The Tax Court subsequently addressed the issue in Carlson v Commissioner, 116 T.C. 87 (2001) and it adopted the IRS’ position.

The Carlson Court noted with some frustration that Congress did not define the word “insolvency” or “assets” as used in Section 108(a)(1)(B) and turned to several dictionaries to find the meaning of “asset.” The court noted three definitions: (i) the property of a deceased person subject by law to the payment of his or her debts and legacies; (ii) the entire property of a person, association, corporation, or estate applicable or subject to the payment of debts; and (iii) the items on a balance sheet showing the book value of property owned. The first two definitions support an exclusion of exempt assets while the third definition supports an inclusion.

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