Sink or Swim? Tax Considerations for Financially Stressed Debtors

by David M. Cox, Esq.

We seem to be cursed to live in interesting times. Many business concerns are facing serious cash flow issues. Money problems bring about marital strife, and financial issues surrounding divorces and business separations are more difficult in times where assets are more difficult to sell. Homeowners are walking away from their homes in the face of unemployment and mounting mortgage debt. Many investors have entered into real estate deals that have gone sour. In troubled times, debtors often neglect tax issues until it is too late to take advantage of some relief provisions in the tax code.

This article discusses in general terms some of the tax planning opportunities that might arise when an overextended client renegotiates debt or relinquishes assets in satisfaction of debt. Many clients seek bankruptcy protection to reorganize or liquidate. Others may attempt to avoid bankruptcy and work out other arrangements with creditors. Both individuals and business entities are contemplated. Different rules apply to different business entities, but in a broader economic sense individuals pay all taxes.

A business owner confronting a cash flow crunch will sometimes consider diverting funds collected for sales, use or payroll taxes for payment of creditors. Once a business gets behind in its taxes the problem tends to compound. State and federal authorities will padlock a business if they conclude that the business is not able to repay taxes in arrears. If the owner or financial officer has failed to pay taxes collected from a customer (sales and use taxes) or from an employee (social security taxes) that person risks personal liability as a “responsible person” for his breach of fiduciary duty to collect and pay over those taxes. A wiser course is to negotiate with creditors rather than “borrowing” money from state or federal governments by failing to pay taxes, especially since these taxes are often not dischargeable in bankruptcy.

The federal tax law relating to debt is deceptively simple. Borrowing money does not result in taxable income. Thus, for example, one might borrow money against the equity in a home and enjoy that money free of income tax. Likewise, the repayment of principal on debt is not deductible. However, if the taxpayer is released from an obligation to repay debt, the release of that obligation is treated as taxable income. This might come about as the result of a loan restructuring, a settlement agreement, a foreclosure, a transfer in lieu of foreclosure, a discharge in bankruptcy, or in some other manner.

The Internal Revenue Code provides relief for certain types of cancellation of debt income. Section 108 allows a taxpayer to exclude income from the discharge of debt arising from: (a) title 11 of the Bankruptcy Code, (b) where the debtor is insolvent, (c) certain farming operations, (d) certain types of real estate debts held by non-corporate taxpayers, and (e) principal residence debt up to $2,000,000 ($1,000,000 for persons married and filing separately). Georgia tax law is substantially similar to federal law in this area.

The exceptions listed above are subject to numerous qualifying rules and definitions, as well as a thicket of regulatory and judicial gloss. Rules often take on added complexity under conventional business structures. Real estate is often held in a separate entity, bringing into play complex rules for allocating liabilities among partners or members and maintenance of capital accounts. Related party rules and the impact of third party and related party guaranties must be considered. State law is relevant in many instances including the nature of each stakeholder’s risk under a debt, and when, and to what extent, the debt will be discharged.

Where encumbered property is transferred to a creditor via foreclosure or deed in lieu of foreclosure, the tax consequences will likely turn on the nature of the debt encumbering the property. If at least one taxpayer is personally liable for payment of the debt, then the transfer is treated as two transactions:

● The property is treated as having been sold at a gain or a loss to the extent of the fair market value of the property; and
● Cancelled or forgiven debt in excess of fair market is subject to Section 108.

If the taxpayer is insolvent, he would have an incentive to attach a low value to the relinquished property in hopes of increasing the amount of income that would be excluded. If the property has a tax basis that exceeds fair market value, and the property qualifies for an ordinary loss, the taxpayer might wish to avoid Section 108 and instead attach a higher value to the property in hopes of generating a larger loss.

If no taxpayer is personally liable for the debt on the relinquished property, then the debt that exceeds the value of the property is added to the sales price and the taxpayer will not have the opportunity to exclude income under Section 108. In some instances, it might make sense to restructure the rights of the parties to the debt before the transfer in order to attempt to qualify a part of the cancelled debt under section 108.

The section 108 exception for insolvency is rife with pitfalls and opportunities. This exception only applies to the extent that the taxpayer remains insolvent after the discharged debt is removed from his balance sheet. Careful consideration should be given to any guaranties the taxpayer has granted. Exempt assets such as retirement plan assets are taken into account in determining whether the taxpayer is insolvent. The taxpayer should be ready to prove the fair market value of any real property in question. The taxpayer should expect the IRS to challenge any transfers to family or agents. All such transfers should be bona fide and not an attempt to defeat creditors.

Debt cancellation issues require an interdisciplinary approach involving the client’s accountant, a debtor-creditor attorney, and someone with some tax expertise. If careful attention is given to planning for a debt cancellation event the tax savings can be very substantial, certainly enough to make the difference between a client being able to start anew or being saddled with tax problems for some years to come.