The Tax Implications of Restructuring Business Debt

Restructuring or modifying business debt can seem like a wise financial move, but it’s important to consider the potential tax consequences before proceeding. This process can trigger unexpected tax bills, cancellation of debt income, or other issues. Let’s explore some key tax considerations when renegotiating business loans.

What Constitutes Debt Restructuring?

Any “significant modification” to an existing debt agreement is considered restructuring for tax purposes. This includes:

• Reducing the principal loan amount or interest rate
• Extending the repayment term
• Adding or removing loan covenants
• Changing the nature of the debt instrument itself

Even subtle tweaks like altering the timing of payments could trigger a taxable event. Consult a tax advisor before making any changes to understand the implications.

Cancellation of Debt Income

One major consequence of debt restructuring is “cancellation of debt” (COD) income. This occurs when a lender forgives part of the loan principal and accepts less than the full amount owed.

For example, if a business owes $100,000 on a loan and the lender agrees to accept $80,000 as payment in full, the $20,000 reduction is treated as COD income. This phantom income is taxable unless an exclusion applies.

There are exceptions that allow COD income to be excluded:

• If the cancellation occurs in a bankruptcy case
• If the business is insolvent before and after the cancellation
• If the canceled debt is “qualified farm debt”
• If the canceled debt is “qualified real property business debt” up to certain limits

Consult a tax professional to determine if any COD exclusions might apply.

Gain/Loss on Loan Modification

Restructuring a loan can also trigger capital gain or loss, even if the principal balance doesn’t change. This occurs when the modified loan terms are substantially different from the original agreement.

Essentially, canceling the old debt is treated as a sale or exchange, while the new restructured loan is treated as a repurchase. If the principal amount of the new loan exceeds the old loan’s adjusted issue price, the difference is a taxable gain. If the principal of the new loan is less, that results in a deductible loss.

For example, if a business owes $100,000 on a loan with an adjusted issue price of $90,000, and restructures the loan so the principal is reduced to $80,000 – the $10,000 reduction triggers a $10,000 deductible loss.

Timing of Taxable Income

Any COD income or capital gain resulting from debt restructuring is recognized immediately in the year the loan modification occurs. This can create a large tax bill if significant debt is reduced or forgiven.

Proper tax planning is essential to avoid unexpected consequences. For example, some taxpayers might consider restructuring loans in stages over several years to spread out the tax impact.

Other Tax Issues

• The original issue discount (OID) rules may apply when debt is restructured. This affects how interest deductions are calculated.
• State income taxes also apply to COD income in most states. Some states fully conform to federal COD rules while others have variations.
• Alternative minimum tax (AMT) exemptions might not apply to COD income, increasing AMT exposure.
• If the canceled debt was used to acquire depreciable business assets, special basis reduction rules apply. This prevents double-tax benefits by reducing the basis of the associated assets.
• If any original loan balance was secured by business assets, a restructuring could trigger depreciation recapture if the security interest is reduced.

Get Professional Guidance

The tax consequences of restructuring business debt can be quite complex. Work closely with both a business tax advisor and the lender when considering any loan modifications to model the tax outcomes. Careful planning can help minimize negative tax surprises.

With proper guidance, renegotiating business loans can help free up cash flow and provide other benefits. But it’s critical to be aware of the tax implications first to ensure it aligns with your overall financial objectives. Consult the tax experts before making any moves.